Essential Investing Lessons From the Book "Thinking Fast and Slow"
Tips to control our minds to make better investing decision
The book "Thinking Fast and Thinking Slow" by Daniel Kahneman describes the way people make decisions - and how they fail to do so. He argues that many of our most common assumptions are wrong, and that we often make irrational decisions based upon emotion rather than logic.
Daniel Kahneman's earlier work in behavioral economics won him the Nobel prize in 2002. His empirical findings challenge the assumption of human rationality prevailing in modern economic theory. With Amos Tversky and others, Kahneman established a cognitive basis for common human errors that arise from heuristics and biases (Kahneman & Tversky, 1973; Kahneman, Slovic & Tversky, 1982; Tversky & Kahneman, 1974), and developed prospect theory (Kahneman & Tversky, 1979).
It's important for investors to understand their emotions and biases they face when making decisions. And Kahneman explains this behavioural theory better than anyone.
We have a lot to cover so let's jump in.
How humans make decisions
Cognitive biases are often irrational behaviors we fall prey to. They are often based on our brain’s tendency to look for patterns where none exist. This is because our brains are hardwired to find meaning in what we see around us. For example, we tend to overvalue things we know well and undervalue those we don’t.
We also tend to value things that are familiar and devalue those that are unfamiliar. These cognitive biases cause us to miss out on opportunities and overlook information that could help us reach our goals.
Our brains are hardwired to seek patterns where there aren’t any. This makes it difficult for us to think critically about situations and difficult questions. Investors are the worst. They tend to take mental shortcuts and not dig deep enough into the technical and fundamental thesis for their investments.
The human mind instinctively responds to heuristics
Humans are creatures of habit. We like routine. And we often make snap judgments about things without fully considering the situation. This tendency is called heuristic thinking. For example, you might decide to buy something because it’s on sale. You might think you’re getting a good deal even though there’s no guarantee that you’ll actually save money. Kohl's department stores became a major brand on this heuristic alone.
Heuristic thinking is an instinctual way of making quick decisions. But it can lead us astray. In fact, researchers have found that people tend to overestimate how much risk they will actually take in investing. And that can lead to erroneous strategic decisions in forming our investment portfolio.
To get around this bias in thinking, here at BarbellAlpha.com we recommend putting 80% of our portfolio in safe, stable investments. This is mostly cash and Treasuries. Advanced investors can use stocks here, but in that case it's very important to take steps to limit the risk. We'll talk a lot about these kind of strategies.
We can also put too much faith in underpowered studies. These are studies where researchers used too small of a sample size to study certain topics.
Investors also tend to focus on losses rather than gains. These biases can cause investors to lose sight of what really matters — long-term returns. This allows them to draw conclusions from data sets that aren’t statistically significant.
Availability Bias: Relying too much on how easily information comes to mind
Availability bias is a cognitive error we make when we rely too heavily on what is easiest to recall. This makes it harder for us to see the truth because our minds are focused on the most accessible information rather than the best evidence.
We tend to think about things we can imagine better than those we cannot. For example, people are more likely to imagine themselves being hit by lightning than actually getting struck by one. In fact, people are more afraid of dying in a car accident than they are of dying in a plane crash.
Media coverage of deaths and accidents increases fear. A study found that media reports of fatal traffic crashes increased traffic fatalities by 10% within three months. Another study showed that news coverage of fatal car accidents increased the number of fatal accidents by 0.3%.
Another important term is intuitive prediction - the idea that people tend to overvalue recent experiences. If someone tells you that they won $100 playing poker yesterday, you probably assume that they’ve done well in the game today too. But that doesn’t mean that you should bet against them. Instead, you should consider whether they’re likely to win again tomorrow.
Confirmation Bias
When we ask ourselves questions, such as "How much do I weigh?" or "What are my chances of getting cancer?", our brains quickly go into overdrive processing the data we've been given. But we're not necessarily looking for the answer that makes sense; rather, we're seeking out evidence that confirms what we already believe. This cognitive bias is known as confirmation bias.
Investors will commonly seek out information that confirms their investment thesis. They want to feel smart for having made an investment. But they fail to look for the opposite opinion. This is where investors can learn more. By learning the opposite side of the argument, they can look for any holes in their thesis.
People also do this in the daily lives with politics...Especially in the current environment in 2022. They'll make conclusions about people of the opposite party without listening to what they have to say. Most people are sheep and blindly follow whatever political party they support. It's an "us vs. them" mentality.
It's important to introduce some cognitive dissonance in our lives and learn the opposite viewpoint. This one thing alone can help us be better investors... And thinkers.
Attentional Biases
We pay attention to things that interest us and ignore or forget things that don't. For example, most people aren't interested in learning about how to make money online. However, if you tell someone that you want to learn how to make money online, they'll probably listen intently. On the flip side, if you say you want to learn how not to lose weight, many people won't even bother listening.
But the devil is in the details for investments. Doing the dirty and finding the small details can be the different between making a lot of money and retiring poor.
What You See Is All There isn't
People tend to focus on the negative aspects of a situation while ignoring the positive ones. For instance, most people think that losing weight is difficult, but it doesn't have to be. If you tell someone that you're trying to lose weight, they might assume that you're struggling to find ways to eat less food and exercise more. In reality, though, you could simply be eating healthier foods and exercising regularly.
We have a Two System way of thinking — System 1 (Thinking Fast), and System 2 (Thinking Slow).
The human brain is a complex organ, and it’s hard to understand how it works. But there are some things you can do to improve your ability to make better decisions. One of those things is to slow down and use System 2.
System 1 is fast, automatic, intuitive, subconscious, emotional, and impulsive. In contrast, System 2 is slower, analytical, conscious, deliberate, rational, and logical. This system allows us to process information, make decisions, and act.
We spend most of our time in System 1
Most of the time, we think and act according to System 1. System 1 is fast, automatic, intuitive and unconscious. It’s the part of our brain that makes snap judgments based on experience, intuition, and emotion.
System 1 doesn't just make decisions; it creates them. It does this by filtering out information that contradicts our beliefs and assumptions.
But most people don’t know how to switch into System 2. They rely on System 1 because it makes life easier. Unfortunately, relying on System 1 often leads to making poor choices.
In fact, even though System 1 is faster, it doesn’t always work well. For example, if you want to remember something, you might write it down. But writing is much slower than remembering. So you end up spending more time writing than you would have spent just memorizing.
That’s why it’s important to learn how to switch over to System 2.
System 2 is slower, deliberate, analytical and conscious. It's the part of our brain responsible for logic and reason.
You can start by slowing down. If you find yourself getting frustrated while trying to figure something out, take a step back and analyze the situation. Then ask yourself whether you’re approaching the problem logically.
If you’re still stuck, ask someone else for help. Or, if you feel like you’ve already tried everything, go ahead and give up. Just keep in mind that you wasted time. But that's alright, you don't want to waste more time.
You can also practice switching over to System 2 by asking questions. Instead of jumping straight to conclusions, ask yourself, “What does this mean? What evidence am I seeing here? How could I test this theory?”
When System 1 encounters something unexpected—like an emergency situation—it triggers System 2.
Our brains are constantly working to keep things consistent. So when we see something surprising, our brain tries to explain why it happened.
In some situations, we don't even realize that we're relying on System 2.
Cognitive Ease: Assuming something is true if it seems familiar
We tend to assume things are truth just because they seem familiar, even though our brains are wired to recognize patterns. In fact, people often make decisions based on how much information they think they have rather than actually knowing anything about the situation.
Cognitive ease is often attributed to system one thinking – the fast, automatic way our brain processes information without having to stop and deliberate over each piece of data.
But there’s another reason why we find it easier to believe something that feels familiar. Our minds are naturally inclined to accept information that matches our existing knowledge base, whether that’s facts we learned in school or assumptions we hold about the world around us.
Narrative Fallacy: Making oversimplified stories of the world
The narrative fallacy occurs when people use simplistic explanations for complex situations. This happens because our brains like stories. They help us to make sense of things. But there is a problem with this. Our brain likes stories, but it doesn't always know what story to tell. So it makes up stories. And those stories often don't match reality.
Daniel Kahneman gave us a good example of why this happens. He told the following story: "A man goes into his kitchen and sees his wife sitting at the table eating breakfast. She says she feels tired today. 'You look exhausted,' he replies. 'I'm feeling fine.' Then he notices some spaghetti sauce on her face. 'What happened?' he asks. 'Oh,' she says, 'the dog ate my homework.'"
In this case, the husband thinks that his wife looks tired because she had a fight with the dog. In fact, she had eaten spaghetti sauce. When you see someone looking tired, it could be because they're hungry.
We do this all the time. If we see something happening, we think that it must be caused by something else. For instance, if you see a person walking down the street, you might assume that they're lost. Why? Because you've seen many people walk down the same road without being lost. You've never actually met anyone who was lost. So it doesn't make any sense.
But this isn't just true for strangers. We make assumptions about ourselves too. We think that we're smart, even though we haven't studied anything. We think that we work hard, even though we didn't put much effort into our jobs. We think that we care about others, even though no one ever asked us to show it.
Narratives are oversimplifications. They're easier to understand than complex situations. But they aren't necessarily accurate.
Investors need to watch out for the narrative fallacy because it can lead them astray. It's easy to get caught up in making simple stories about the market. The stock market is full of narratives. People talk about stocks as if they were characters in a movie.
For example, investors may say things like “This company has been undervalued for years. I'll buy shares now before everyone realizes its value." Or, "This company is going to release a hot new product soon. I should sell my shares right away so I can profit off the rise in share price."
These kinds of statements are examples of the narrative fallacy. They're oversimplified stories that don't reflect reality. It could take years for the market to realize what you see in a company. Especially if there is no immediate catalyst to cause the stock to rise. And not all product launches are a time to sell a company - sometimes the launch is so good you should continue holding the stock for years.
Investors shouldn't fall victim to these types of stories. Instead, they should focus on the facts. Facts are more reliable than narratives.
Your Brain Has High- and Low-Energy Consumption
Our brains use two different types of energy. There's high-energy consumption, and low-energy consumption.
High-energy consumption is used when we're focusing on tasks like reading books, doing homework, writing reports, and playing video games. These activities require lots of focus and concentration. They also demand a lot of mental resources.
Low-energy consumption is used for activities like watching TV, listening to music, talking to friends, and hanging out. These activities don't require much attention, and they don't drain us mentally.
When you're working hard, your brain is using up high-energy consumption. If you're taking a break, it's using up low-energy consumption. So why does it matter? Because when you're busy, you're using up high-energy. And when you're relaxed, you're using up low-energy.
Investors should spend a lot of time in high-energy consumption states. We should be reading books, learning how to read charts, trading options. And we should be concentrating on deeply on these so we can move the important information into our long-term memory (more on that below).
But we should know if our brain is worn out from this work. If we're tired, it is not a good time to place trades or make important financial decisions. You'll end up defaulting to "fast" thinking and have a greater potential to make a non-optimal choice.
Choose Which System Your Brain Uses
The human brain consists of two different types of memory systems. One system stores information into long term memory; the other stores it into short term memory. Long term memory allows us to remember facts, dates, names, places, etc., while short term memory helps us process information we are learning.
As humans, we tend to use whichever system best suits the task at hand. For example, if you want to study for a test, you'll probably focus on storing information in long term memory. However, if you're playing video games, you might choose to store information in short term memory because it's easier to do so. Although oftentimes when growing up, I found the opposite happened. But what can you do?
When you try to learn something new, you don't always use the same type of memory system. If you're trying to memorize a fact, you'll likely use short term memory. But if you're trying to solve a problem, you'll probably use long term memory. This is why solving a math equation requires thinking differently than remembering a phone number.
If you want to improve your ability to learn, you must train both of your memory systems. To do this, you'll need to switch between them frequently. Try to memorize a few facts, then ask yourself how you could apply those facts to a real life situation. Then, go back to the facts and see what else you can figure out. Finally, take some time to write down everything you learned. Doing so forces you to use your long term memory, which makes it much harder to forget anything.
Filtering the information we read is important as investors. It helps us build our mosaic. Becoming good at this helps us remember important information and forget about the short-term noise.
The Halo Effect Clouds Our Judgment
We are prone to halo effects—the tendency to see positive traits in people we like, and negative ones in those we dislike. This bias makes it difficult for us to accurately judge how likely someone else is to do something good or bad.
In one study, participants rated the likability of strangers whom they had just met. They found that the more likable the stranger, the less likely they were to believe he was trustworthy.
In another experiment, researchers asked participants to read short stories about people they didn't know. Participants tended to make judgments about the character in the story based on their general impression of the person described in the story rather than on the actual behavior shown in the story. These biases can lead us astray when making decisions about whether to trust someone or to hire him or her.
The same is true when reading about companies we invest in. It's likely if the average investor reads another article about Meta Networks ( $META ) and how its Facebook application tracks user data they will ignore the company. They'll say "I knew it was bad." But they'd likely overlook the fact it's currently trading at a basement bargain price of 7x free cash flow.
And if we read another article about Elon Musk and Tesla saving the world through its electric vehicle production, it's likely we'll want to ape even larger into a position... And ignore any other facts that may show it is overvalued... Or that the overall market is going down.
Conclusion
Daniel Kahneman's Thinking, Fast and Slow is about how we actually think, and why we behave the way we do. It explores our beliefs, values and attitudes, and explains how they affect our decisions.
It's very important to understand behavioural finance biases so we don't make mistakes with our hard earned money.
This is a book I recommend re-reading every couple of years to keep these biases and heuristics fresh in our mind.