“If there is time to reflect, slowing down is likely to be a good idea.” – Daniel Kahneman
Thinking Fast and Slow is a fascinating book by Nobel Prize winner Daniel Kahneman. It is full of interesting studies that have been performed over the years to learn how to think about thinking and how we generally react to different situations.
There are investment implications is this book but also behavioral studies that we can use outside of our finances.
SYSTEM 1 & SYSTEM 2
The main point of the book is that we have two basic ways of processing our thoughts, which Kahneman calls System 1 and System 2. System 1 is our intuition. System 2 is our more logical, deliberate way of processing thoughts and thinking things through.
System 2 is lazier than System 1, which causes us to use hunches based on System 1 when we are presented with too much information.
The amazing characteristic about our System 1 intuition is that we are rarely stumped in any situation. Our brain can make split second decisions without any effort on our part at all and we have no voluntary control over this aspect of our brain.
This system is helpful in certain situations, but it can also get us into trouble because it can be emotional. System 1 is biased to believe and confirm. It also focuses on existing evidence and ignores lacking evidence. Kahneman calls this “what you see is all there is.”
With your investments, this is called having a confirmation bias. Many times we find an opinion about the markets or a stock that we agree with and we look for further research that confirms our beliefs. What we should do is seek out alternative points of view to have all of the information to make an informed decision using our System 2 thought process.
Some call this seeing both sides of every trade. By seeking out differing views from our own we can make better decisions without falling into the trap of making our research one sided.
One of the reasons that we continue to have a confirmation bias in our thinking is that we tend to let overconfidence affect our decisions.
In a study mentioned in the book, Duke University conducted a survey of CFOs of large corporations asking them to predict the S&P 500 performance over the following year. They found the CFO’s estimates and the actual results had a correlation of slightly less than zero (no statistical relationship). The most overconfident CFOs on the S&P were also the most overconfident about their own firm’s results, so they took more risk.
Obviously, over time in the capitalist system, it has paid to be optimistic about the future. The trend has been up over time so you have been rewarded by having a positive outlook over the long-term. Where overconfidence can be a problem is when we let it affect our short-term decisions and extrapolate the recent past into the future.
So while we need to keep an optimistic view of the future, there is a fine line between being optimistic over the long-term and being overconfident about our own abilities in the short-term.
System 1 also responds more strongly to losses than to gains. This is called loss aversion. Most studies show that losses are twice as powerful as gains on our psyche.
You would think that we can’t possibly be prone to being overconfident in our abilities and have an aversion to loss because they are conflicting in nature. Kahneman explains this by showing that we either ignore risks altogether (overconfidence) or give them far too much weight (loss aversion) with almost nothing in between.
We tend to think and act in extremes. This is another reason that we will continue to have manias and panics in financial markets. We just can’t help but get caught up in the cycle of fear and greed.
The most interesting loss aversion study in the book dealt with professional golfers. A study was performed to analyze more than 2.5 million putts to see if golfers had better concentration when putting for par (thus avoiding a bogey) rather than putting for birdie (gaining a stroke).
They measured easy and difficult putts from every distance, and the results showed that the golfers were much more successful when putting for par than for birdie. The conclusion of the study was that it’s harder for the golfers to accept losing a stroke (by missing a par putt) than it is to gain a stroke (by making a birdie).
Hard to believe, but true that for most of us, losses loom larger than gains. This shows up in our investment accounts when we hold onto losing positions because we don’t want to lock in losses. Instead of looking at our holdings objectively and basing the decision on the valuation of the investment, we hope that it will come back to our original cost.
Unfortunately, hope is not an investment strategy. Our tendency to have an aversion to loss is a good reason to pay less attention to the market on a daily basis. This is because the pain of seeing frequent small losses exceeds the pleasure from equally frequently small gains.
Kahneman suggests only checking your investment balances on a quarterly basis to avoid making System 1 decisions based on daily changes in the markets.
The main takeaway from Thinking Fast and Slow is that situations and experiences change, but human nature is constant. Bubbles and busts have been happening since the dawn of financial markets and they will continue to happen going forward.
Using System 1 and making quick decisions is helpful in certain situations but not necessarily when making long-term financial decisions.
Another highly publicized study in the book looked at the results of 10,000 investor brokerage accounts to see how trading activity impacted investment performance. The researchers looked at 163,000 trades over a 7 year period. They found that, on average, the stocks that investors sold did better than the ones they bought by 3.2% per year.
They also found that, on average, the most active traders had the poorest results, while the investors who traded least earned the highest returns. Men acted on their ideas more often and therefore women had much better results (many studies over the years have shown that women have a better temperament for investing than men).
When making investment decisions it makes sense to take your time and allow your System 2 thought process to kick in and help you make more informed decisions. They won’t always be the right decisions, but having a long-term outlook will serve you much better than thinking short-term with your finances.
Thinking Fast and Slow
Here’s a video featuring Kahneman explaining System 1 and System 2:
Daniel Kahneman on How Your Brain Leads You Astray