In 2002, the Royal Swedish Academy of Sciences awarded Daniel Kahneman the Nobel prize in economics. His choice was surprising at the time because Kahneman is a psychologist, not an economist. His contribution to economics—and it was huge—consisted in demonstrating how our cognitive foibles sometimes get in the way of rational economic decisions. You can learn more about Kahneman’s findings in his
book “Thinking Fast and Slow.” If you haven’t read it, I highly recommend it.
According to Kahneman, most of us are unaware of the biases in our thinking. However, these biases get in the way of sound decision making. If you want a taste of what he means, try the following experiment—something Kahneman calls “the Linda problem.”
Participants in the experiment were told, “Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student she was deeply concerned with issues of discrimination, social justice, and also participated in anti-nuclear demonstrations.” Given those facts, which of the following is more probable: 1) Linda is a bank teller, or 2) Linda is a bank teller and is active in the feminist movement?
If you chose option 2, you are part of the overwhelming majority who got it wrong, including 85 percent of the students in Stanford’s Graduate School of Business. Think of it this way: feminist bank tellers are a subset of all bank tellers, so the probability of option 1 must be greater.
This is only one example of how our rational, analytical brains can get hijacked by our cognitive biases. It isn’t a case of emotion clouding our judgment. Rather, it is more like an intermittent bug in the code. According to Kahneman, this bug is the result of two types of thinking going on in our brains at the same time, thought processes he calls System 1 and System 2.
System 1 thinking is fast, intuitive and often unconscious. It is the kind of thinking that allows you to safely drive from point A to point B with little recollection of the journey. System 1 thinking takes existing patterns of thought and applies them to new information instead of letting the new information form its own patterns.
System 2 thinking, on the other hand, is slower and more laborious. It consciously weighs facts and analyzes potential consequences. It is logical, but it can also be lazy or tire easily. In fact, Kahneman hypothesizes that most people miss the Linda problem because System 1 thinking jumps to the wrong conclusion and System 2 is too lazy to resist or refute it.
There are times when a fast System 1 response is good enough, even if it isn’t perfect. For example, when the consequences of a mistake are low, System 1 thinking can often suffice. We don’t need to spend hours price shopping a purchase in order to save a couple of bucks. Likewise, traders sometimes need to think quickly about market developments in order to seize fleeting opportunities.
On the other hand, there are other times when System 1 thinking can get in the way—especially for long-term investors. On days when the market comes under pressure, we should ask ourselves if we are letting short-term market swings undermine confidence in a sound long-term strategy. For long-term horizons, System 2 thinking is usually more profitable.
There is a lot more to Kahneman’s work than I can possibly touch on here. To learn more, I recommend you get a copy of his book and settle into a cozy nook for some quality System 2 time.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to: firstname.lastname@example.org