This article is the second part of our series on decision making. Applying some of the information from Thinking, Fast and Slow, we are diving into the research from Nobel Prize winner Daniel Kahneman and how he breaks down our decision-making process into two systems.
Notes from Better Thinking...:
To keep things simple Kahneman breaks down our thinking process into two systems that he describes as “System 1” and “System 2.”
System 1 is intuitive and emotional, fast and easy. It is reactive. “There was a shark attack last week, I am never going to the beach again.”
System 2 is deliberative and logical. It is also slow and requires effort. “What are the chances of getting attacked by a shark? Is swimming in the ocean more dangerous than swimming in a community pool?”
The challenge with our System 1 and System 2 thinking is when we "think" we are an expert, or we have a life experience that impacts us. This perception of “expertise” or the impact of life experience can shape our decision-making process in a profound way.
That’s because life experiences build the heuristics that we use as short-cuts to make System 1 decisions. Some of these heuristics are helpful, and some are not.
If I were to ask you what is more probable: Dying in a train accident or getting struck by lightning?...Most people would say train accident.
That’s because System 1 kicks in, pulls up memories of train accidents in the news and assumes that there is a higher probability of dying from a train accident than getting struck by lightning.
This System 1 action is referred to as the availability or familiarity heuristic.
But according to the National Center for Health Statistics, we have a higher chance of dying from a lightning strike than we do from a railway accident.
According to that same study, Americans are two and a half times more likely to die from a bee sting than from a dog attack.
Like bee stings, average market gains over long periods of time aren’t as headline grabbing as train crashes or market crashes, so they are not as prominent in our minds.
Investors are quick to succumb to System 1 thinking when we avoid “riskier” asset classes, especially when we have the impact of the great recession burned into the back of our minds.
By focusing all our attention on the potential for short-term fluctuations in performance, we ignore the fact that these “riskier” asset classes can be the ones that have the greatest long-term impact on portfolio growth.
The familiarity heuristic may not only cause us to avoid high-performing asset classes, it can also work against us by biasing us toward things we are familiar with. According to JP Morgan, people living on the West Coast tend to overweight the technology sector, while people living in Texas tend to overweight energy; and people in the Midwest tend to overweight industrials.
While it is wise to invest in asset classes where we have an edge, it is a statistical improbability that the entire universe of Texans has an edge in energy investments. And it’s equally improbable that the entire universe of Midwesterners has an edge in industrials. While System 1 might convince us all that we are “experts,” we can’t all have an edge. Not everyone is the “smartest person in the room.”
The irony of the familiarity heuristic is that it can cause us to avoid “riskier” asset classes on one side and cause us to overweight our portfolio on the other side, ultimately creating more potential hazard from a lack of diversification and concentration risk.
We are all swayed by our personal biases and deceptive thinking from time to time. The key to managing our thinking is to simply recognize that we are inclined to be biased. Rather than reacting to System 1 and our biases, we need to access System 2 and ask ourselves deeper questions.
System 1 thinking looks at the high performing mutual fund and says “this fund has significantly outperformed my other mutual funds in the last two years. Let’s sell my underperforming funds and buy more of this fund.”
System 2 thinking looks at the high performing mutual fund and asks: “Why is this fund outperforming? Did the manager tactically recognize the hot sectors? Or was it always invested in this sector, and this sector happened to outperform the last two years? How likely is it that this sector will continue to appreciate when it is extremely expensive today? Let’s sell half of this holding and move into something that has more potential to grow.”
System 1 thinking looks at a marginal company in a stagnant industry and says: “Wow this company has not grown earnings in the last three years, there is no way I would own this stock.”
System 2 thinking says: “This company has not grown earnings in the last three years, but the balance sheet is stronger today and the market cap is one-third of what it was three years ago. At the extremely depressed valuation, I’m willing to bet that this company will converge back to a more-normal valuation when investors begin to recognize the safer balance sheet.”
Boiling it Down:
System 1 can do a pretty good job of keeping us alive in the jungle, but may not serve us as well when seeking to maximize our long-term wealth.
That’s where we need to recognize that we are inclined to be biased and our short-cutting heuristics may be hurting us. Tapping into the benefits of System 2’s slow thinking can help prevent us from making costly mistakes.