'Thinking Fast and Slow': Two big lessons for investors

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Former US President Barack Obama presents Daniel Kahneman, the author of Think Fast and Slow, the Presidential Medal of Freedom.

On The Value Perspective blog, we aim to extol the merits of value investing, the art of buying shares that are unloved by the market for no good reason.

The summer holidays - and this guest column on City AM - offer an opportunity for us to highlight investing books that can help keen students of value investing.

Unlike our previous two holiday reading tips, The Most Important Thing and Margin of Safety, our next idea is not exactly an investment text.

Thinking Fast and Slow (2011) by Nobel prize-winning behavioural theorist Daniel Kahneman still, however, addresses something any investor ought to care about deeply – how humans make decisions.

How humans make decisions

Simply put, behavioural theory is the study of why we do what we do – out of which has sprung behavioural finance: the study of why we do what we do with our money.

Much of this focuses on so-called ‘cognitive biases’ – human tendencies to think in certain ways and take certain decisions that have more to do with instinct than rationality or good judgement. Either way, they are rarely conducive to sound investment.

In Thinking Fast and Slow, Kahneman has a lot to say on the subject of how our brain works and on a number of these individual cognitive biases – and he says it all in a most accessible and interesting way.

Still, as we have done previously, rather than offering a traditional review of the book, we will instead touch on the lessons we personally took from it. So what were they?

1. Human beings have two ways of thinking

The human brain is a curious thing, working in ways that are not always sensible and rarely easy to understand.

To address this point, Kahneman introduces the idea of ‘system one’ (that is, thinking fast) and ‘system two’ (thinking slow) – or what we might effectively think of as the subconscious and conscious parts of the human mind.

According to the book, our ‘system one’ subconscious reacts and makes decisions automatically for a variety of sound evolutionary reasons and does so with little effort or indeed understanding on our behalf.

For its part, our ‘system two’ conscious is involved in all our deeper thinking but is also inherently lazy and would rather do nothing if an instant judgment is on offer from our subconscious.

Thus, as we wrote in the Inherent risk post on our blog, when we are asked a difficult question, we will often subconsciously ‘flip’ it so that, while only subtly different, it is considerably easier to answer.

For example:

‘How happy are you with your life these days?’ is actually a tough question that involves a degree of thought so we subconsciously jump to a slightly easier one: ‘How is my mood right now?’

Translating this to the world of investment, this means when someone is asked whether they view Company X, say, as a good business, they are more likely to consider how they ‘feel’ about Company X.

Depending on who they are that might take them in various directions but, in all likelihood, their answer will be based more on emotion and gut reaction than the altogether trickier matter of whether Company X may or may not be a good investment.

The real answer to that will, of course, be dictated almost entirely by numbers yet the human brain prefers more ‘touch-feely’ considerations such as brands or pricing power or logos or indeed, in modern-media terms, anything that can be illustrated with a pretty picture.

That is all fine when it comes to filling the pages of the financial press but it is irrelevant in the assessment of the potential quality of an investment.

2. The human mind instinctively responds to heuristics

‘Heuristics’ are essentially mental rules of thumb or short cuts developed over many millennia and through which the human brain sacrifices intellectual rigour for the sake of reaching a speedier decision.

We said it before but it is well worth repeating – such behavioural finance biases can often lead to poor investment decisions.

Kahneman goes into many of these biases in detail, including ‘anchoring’ – where people subconsciously base their perceptions on the current environment rather than recognising that something entirely different could happen in the future – and ‘prospect theory’.

Also known as ‘loss aversion’, this is the idea human beings feel the pain of financial loss twice as keenly as they feel the enjoyment of any gain, as we have discussed here.

Then there is the ‘endowment effect’ – the idea that once you hold a view, you become very attached to it and find it hard to change your position, even if new facts suggest you should – and ‘base rate neglect’.

This has nothing to do with interest rates but involves attributing less weight to more general probabilities and more to newer or more immediate information, which we considered in greater detail here.

We will restrict ourselves here to touching on just two more behavioural finance ‘sins’, the first of which is the ‘law of small numbers’, which can lead to researchers trusting “the results of underpowered studies with unreasonably small samples” – as Kahneman put it last year as he conceded that he himself had fallen into that very trap.

Last up is ‘intuitive prediction’ – a behavioural sin we have not specifically mentioned before, on The Value Perspective.

Intuitive prediction

It is linked, however, to one of the foundation stones of value investing because it relates to the human instinct to make forecasts on what we feel to be right rather the strength of the available evidence – not least how most aspects of life tends to revert to their long-term average.

As we wrote in Mean machine, this concept of ‘regression to the mean’ is a bigger and stronger phenomenon than most people tend to recognise and one that captures many of the subtleties about the world that extrapolating the future from the present does not – competition, say, or a whole host of other factors no-one could hope to understand fully about the difficulties inherent in growing either a business or a country.

In short, then, what Thinking Fast and Slow illustrates time and again is that, when it comes to investing, your brain is not always on your side.

As such, without some sort of framework to keep both it and you honest – and, as we have argued in pieces such as Investment edges, value is precisely that – your brain is going to do everything it can to convince you you are right.

Even when you are wrong.

  • Juan Torres Rodriguez is an author on The Value Perspective, a blog about value investing. It is a long-term investing approach which focuses on exploiting swings in stock market sentiment, targeting companies which are valued at less than their true worth and waiting for a correction.

 

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