Photo: Edward Maurer
When advisors want to understand why their clients make seemingly irrational financial choices, odds are they will find answers in the research of Nobel-winning behavioural economist Daniel Kahneman. But guiding clients toward a better financial future is only one way to apply behavioural finance. Kahneman says we solve virtually all problems, not just financial ones, with two distinct types of thinking.His recent book, Thinking, Fast and Slow, was a 2011 bestseller. It summarizes his lifetime of work on how the mind works, covering many topics familiar to those who follow behavioural economics and finance: prospect theory, overconfidence, loss aversion, anchoring, separate mental accounting, the representativeness bias and the availability bias.
Kahneman, who, at 82, is still teaching at Princeton, recently discussed these and other discoveries at the 2012 CFA Institute Annual Conference, which took place in Chicago on May 6-9.
I’ll look at how Kahneman’s research can be applied in the context of investing, but first let’s examine the central subject of his book: our two ways of thinking.
Think fast! Or think slowly?
Try this experiment: Just before making a left turn in a busy intersection, begin to multiply 17 by 24. I’m kidding; please don’t. You’ll either quickly abandon the arithmetic problem or wreck your car. But I’ll bet you can add two plus two while making a left turn without any problem whatsoever.
What is the difference between the two tasks?
Most people would say that one of the tasks is easy and the other is hard. But Kahneman, who won the 2002 Nobel Prize in economics for work relating economic decision-making to psychology, says that there’s more to it – a substantive difference, not merely one of degree.
Adding two and two is done using what Kahneman calls System 1 thinking, the kind of fast thinking that feels like it is done on autopilot. The product of 17 and 24 is arrived at using System 2 thinking – slow, deliberate thinking that involves an entirely different physiological process, one that (for example) interferes with driving a car.
When you engage in intense System 2 thinking, Kahneman says, something happens to your body. Your pupils dilate. Your heart rate increases. Your blood glucose level drops. You become irritable if someone or something interrupts your focus. You become partially deaf and partially blind to stimuli that ordinarily command your attention. Kahneman writes that “intense focusing on a task can make people effectively blind.”
My grown son recently reported an occurrence of a related phenomenon, blindness caused by having made up one’s mind. While he was preparing to perform in a concert, his girlfriend paid him a surprise visit, hundreds of miles from either his home or hers. Despite increasing efforts to recognise the strangely familiar person approaching him from a distance, he couldn’t figure out who she was until she was quite close. There is nothing wrong with my son’s eyesight. Having decided, using System 1 thinking, that his girlfriend was far away, it was physically impossible for him to see her until she was right under his nose. He was unable to invoke System 2 thinking to figure out that maybe she had taken an unplanned trip. He was temporarily blinded by an idea.
A young boy’s puzzlement about human nature
Kahneman, a World War II-era refugee from Germany, recalls that he first became interested in psychology when, as a young child, a German police officer asked to talk to him. Rightly terrified of the officer, young Danny Kahneman, a Jew, discovered that the officer was interested in him because he reminded the officer of his own son, who had died. The officer became very emotional when conversing with Danny, gave him money, and kept him safe.
From that point forward, Danny decided to figure out what made people tick.
Thinking, Fast and Slow reads like a primer, romping through familiar territory, but that is because Kahneman was instrumental in discovering much of what he discusses. Younger scholars such as Richard Thaler, Shlomo Benartzi, Hersh Shefrin, and Meir Statman may have gotten to the reader first, but Kahneman and his deceased collaborator, Amos Tversky, are the true source of most of these insights.
Systems 1 and 2 in focus
The phrase “what you see is all there is,” a play on the old adage “what you see is what you get,” runs through the book like a mantra to describe System 1 thinking. System 1 takes visible evidence as the only source of knowledge, and ignores hidden evidence. Centered in the brain’s amygdala (a part of the limbic system or “reptile brain”), System 1 evolved in response to the need to obtain quick answers. Over here is a tiger: danger! Over there is a pheasant: delicious! Those who needed to think slowly and carefully to arrive at these conclusions did not survive to become our ancestors.
System 2 is more complex, and resides in the brain’s prefrontal lobes, which are well developed in humans but not in other animals. System 2 recognises that what you see is not all there is. Is Steve, “a meek and tidy soul, with a need for order and structure, and a passion for detail” a businessman or a librarian? While System 1, spotting the resemblance between the description and the librarian stereotype, shouts out “librarian,” System 2 recognises that the number of librarians, relative to businessmen, is tiny and that Steve is actually more likely to be a businessman, despite personality traits that might have made library work a better fit.
In Kahneman’s telling, System 2 clearly produces the superior answers, at least in most situations. A great deal of Thinking, Fast and Slow is devoted to demonstrating, through psychological experiments, how System 1 gets it wrong. “How many animals of each kind did Moses take into the Ark?” “Two,” says System 1. “You’re trying to fool me,” says System 2. “It was Noah.”
These two conflicting brain functions behave differently in noteworthy ways. System 1 doesn’t mind working all the time, for example, because its work is not that hard. When System 2 is put to work, it requires so much effort that it takes over the whole body, so it goes to work only reluctantly. People do not shy away from solving problems requiring a quick, automatic reaction but, perhaps because they anticipate the physical strain described earlier, they procrastinate in working on questions that require careful thought. No wonder young kids hate word problems in maths class: word problems test the ability to puzzle out what maths problem the questioner wants solved, a task much harder than doing the underlying arithmetic.
Malcolm Gladwell’s beautifully written Blink is essentially an argument that System 1 thinking produces the superior answers. When Kahneman catalogues the errors of System 1 thinking, some laughable and some tragic, it becomes obvious that Gladwell’s celebration of snap judgment is terribly flawed. I am being a bit unfair to Gladwell because he does expend some effort identifying when quick thinking goes awry. But his antagonist, David Adler, whose book, Snap Judgment, is a response to Gladwell, makes the far better case that judgments rendered in the blink of an eye are usually wrong, and that it is necessary to apply System 2 thinking if one is serious about coming to sensible answers to most questions.