In 2011, Daniel Kahneman, who shared the Nobel Prize in Economic Sciences in 2002, published his best-selling book, Thinking Fast and Slow. The book summarizes the decades of research he performed, often in collaboration with Amos Tversky. The broad theme of his research is that human beings are intuitive thinkers and that human intuition is imperfect, with the result being that judgments and choices often deviate substantially from the prediction of normative statistical and economic models. The broad field of behavioral economics might not have even existed without the fundamental work that Kahneman and Tversky performed.
The book focuses on our two systems of thought — “System 1” is fast, intuitive and emotional; “System 2” is slower, more deliberate and more logical — which are used to process information. If you are a fan of the original Star Trek series, Captain Kirk might be thought of as the System 1 thinker. Mr. Spock was most definitely all about System 2. While Kahneman’s academic training was in psychology, he is effectively what we call a Behavioral Economist. A large part of his work focuses on the decisions investors make by trying to sort out problems by using System 1 rather than putting in greater effort and letting System 2 do the work. Kahneman discusses in a fairly detailed manner the numerous cognitive errors that investors can make.
Among the many conclusions reached by Kahneman is that the human mind simply cannot function well in the world without both System 1 and System 2. While we do not need System 2 to know that we should get off the train tracks when a train is approaching, we have to be careful about relying too much on System 1. Otherwise, our snap judgments could be the only judgments we make on a particular subject. In the world of investing, this laziness can ultimately result in financially destructive behavior.
Take a look at the following three questions:
1. A bat and a ball cost $1.10 in total. The bat costs a dollar more than the ball. How much does the ball cost?
2. If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?
3. In a lake, there is a patch of lily pads. E very day, the patch doubles in size. I f it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake?
If you use only System 1, you will most likely get all three answers wrong. If you use System 2, your chances of getting them right will increase. (The answers are at the end of this article.)
For investors, the true power of this book results from the combination of Kahneman’s thoughts on (1) how we frequently self-sabotage our results due to our erroneous biases or prejudices, (2) how we incorrectly use examples to form broad conclusions on entire groups (or “populations”) and (3) how we can dramatically improve our ability to make correct predictions by using what is called a group’s “base rate.”
While this may sound quite complex, Kahneman truly does a great job of identifying and explaining the major mistakes in human judgment. If investors understand these pitfalls, they can include elements in their investment process that can potentially minimize the chances of being impacted by them. In short, being able to understand cognitive biases can lead to better buy, sell, or hold decisions.
MAKING BETTER DECISIONS
Oftentimes, we find ourselves torn between emotion and logic in our personal lives as well as when we are making investment-related decisions. Even though we may think the majority of our decisions are based on logic, it is surprising to learn how many are actually influenced by emotion. To complicate matters even more, we also know that people decide differently under pressure or if high risks are involved — exactly the kind of scenario experienced by investors. Kahneman further explains these ideas in his discussion of Prospect Theory (the basis for his Nobel Prize), which highlights how the fear of loss or the temptation for high returns skews our rational mind. We find that investors expend too much energy trying to avoid making hard choices by looking for an informational advantage that will guarantee them a “sure thing.” Instead, investors should simply focus on making better decisions.
In other words, we can probably improve our results by making better decisions with available information, rather than trying to find better information. Understanding the psychological behavioral components of investing can help us improve our decision
making as well.
HOW RELYING ON SYSTEM 1 CAN FAIL US
Kahneman does not suggest that we are incapable of System 2 thought or that we always follow our intuition. System 2 engages when circumstances require it. Instead, many of our actual choices in life, including some important and consequential ones, are subject to substantial deviations from the standard statistical model. While System 1 can lead to brilliant inspiration, it can also cause systematic errors.
For example, consider one of Kahneman and Tversky’s best known questions/experiments:
An individual has been described by a neighbor as follows: “Steve is very shy and withdrawn, invariably helpful but with very little interest in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail.”Is Steve more likely to be a librarian or a farmer?
If you reply quickly to this question, you are apt to say that Steve is more likely to be a librarian than a farmer. The description of Steve is meant to lead you to this conclusion. He certainly sounds more librarian-like. However, there are five times as many farmers as librarians in the U.S.
Further, the ratio of male farmers to male librarians is even higher. These latter facts are called base rates. They do not ordinarily come to mind, preventing an accurate computation and answer – Steve is more likely to be a farmer. For most of us (including this writer on first reading), System 2 does not engage.
For many investors, it is often much more difficult to sell a stock at a loss than at a gain. Kahneman found that individuals are risk averse in the domain of gains, and risk loving in the domain of losses. This point of view is supported by experiments in which individuals choose a gamble with a 50% chance of losing $1,000 over a certainty of losing $500. He sees this concept (loss aversion) as the most important contribution of Prospect Theory to behavioral economics. It is further seen in a basic experiment in which people refuse to take bets that give them a 60% chance of winning and a 40% chance of losing a dollar, even though such a refusal implies an implausibly high level of risk aversion. Kahneman justifies this assumption by noting that biologically our brains might process losses in the same way as threats.
In addition, Prospect Theory argues that the value people place on a change in probability (e.g. of winning something) depends on the reference point: people place greater value on a change from 0% to 10% (going from impossibility to possibility) than from 40% to 50%, and place the greatest value of all on a change from 90% to 100% (going from possibility to certainty).
A WAY TO ENGAGE SYSTEM 2
If you are concerned that your brain does not engage System 2 enough, Kahneman suggests that frowning can activate the skeptic within us, or System 2. Putting on a frown, experiments show, works to reduce overconfidence; it causes us to be more analytical, more vigilant in our thinking, to question stories that we would otherwise unreflectively accept as true because they are simple and coherent.
While we do not profess that we can always avoid all the behavioral biases discussed in Thinking Fast and Slow, we do our best to put processes in place to help avoid the potential impact of these errors. On the evening of May 19th, we will be hosting a seminar to discuss Kahneman’s book in more detail. We hope those of you who are interested in learning more about why people behave the way they do will join us.
1) The ball costs $0.05 and the bat costs $1.05. Don’t feel bad if you missed this one. More than 50% of students at Harvard, Princeton, and the Massachusetts Institute of Technology routinely provide the incorrect answer.
2) Five minutes.
3) Forty-seven days.