Thinking, Fast and Slow—Daniel Kahneman
Most people reflexively think of themselves as rational, clear-minded and fact-driven thinkers. Yet is this so?
Daniel Kahneman has spent a lifetime researching just that—and, along with his partner, Amos Tversky, won the 2002 Nobel Prize in economics for the development of prospect theory—a model for how people manage risk and uncertainty, identifying that gains and losses are valued differently. The heart of prospect theory is folks dislike or fear losses more than they seek or enjoy equal-sized gains—a phenomenon known as loss aversion. So who better to pen Thinking, Fast and Slow—an engaging, easy-to-read but meticulous look into how we humans think?
Kahneman and Tversky challenged the long-held assumption we are rational in our decision-making process, consciously considering (and aware of) all factors and possibilities. Their broad views are broken down into numerous heuristics and cognitive biases (such compartmentalization is the hallmark of psychology as science), through which we attempt to quickly derive judgment.
And here, in one single tome, is Kahneman’s life’s work. While not specifically written as an investment book, Thinking should be considered an essential tool. Kahneman highlights, with joyous delight, our weaknesses and biases in an illustrative and engaging manner. Awareness of them can save you some real heartache.
The human mind, in Kahneman’s view, is comprised of two operating components, which he terms “System One” and “System Two.” System One is automatic, unthinking and always functioning. It guides us through basic routines: getting dressed, driving to work, eating lunch. System One is a model of evolved efficiency, having successfully guided our ancestors away from saber-toothed tigers and other threats. System Two, on the other hand, requires allocation of attention and effort. System Two oversees System One and will interfere when decisions conflict with logic, morality or self control. Requiring effort, System Two is inherently lazy and prefers to default tasks to System One. Kahneman theorizes this is what leads us to make cognitive errors.
Sounds fairly dry and academic—but dry the book is not. With a light, flowing style, he takes us through a series of experiments on human reactions to everyday problems, showing how our brains often don’t provide the logical outcome. He created “the Linda problem” (to assess the influence of irrelevant information) and writes of thrusting hands into ice water in painful trials (to measure duration effect and peak-end rule). He asks about probabilities: Would you prefer to blindly select one red marble from a jar with ten white marbles or blindly select one of eight red marbles from a jar with one hundred white marbles? Are you more incentivized to putt for a birdie or to save par? Kahneman provides a wonderfully entertaining glimpse into the unthinking process of thinking.
Even in the very best books, there are nits to pick. Here, Kahneman can contradict himself when applying his observations to capital markets. He states: “Few stock pickers, if any, have the skill needed to beat the market consistently, year after year,” failing his test of “persistent achievement.” Rather, he invokes Burton Malkiel’s “random walk” efficient market hypothesis, wherein luck is the only differentiating factor in a manager’s returns year over year. Those years in which luck shines on an investor, Kahneman believes, create an illusion of validity and skill.
Of course, it’s true most well-known managers fail to beat their benchmarks over long time periods. But Kahneman’s statement seems mostly like a generalization, and one that doesn’t square with all available evidence. So while there are admittedly few money managers with long-term histories of outperformance, they do exist. My boss, Ken Fisher, being one—and one whose performance history isn’t driven by only one or two super-lucky years. Does this pass Kahneman’s verifiable “persistent achievement” test?
Ultimately, Kahneman’s generalization doesn’t address differences in process and approach—things like the application of capital markets technologies (interpreting widely known factors differently and correctly) or recognizing history’s lessons in real time. (Detailed well in Fisher’s latest book, Markets Never Forget.)
Further, Kahneman feels expert judgments would be better replaced by math-based models to asses anything ranging from future valuation of Bordeaux wines to predicting a soldier’s future performance—and especially in portfolio management. Kahneman is correct in arguing for a disciplined, scientific approach but he fails to acknowledge many judgments and historical contexts are necessary in a complex, evolving and adaptive system like capital markets.
Applying System Two will demonstrate investors commonly repeat cognitive errors due to the influence of unrelated biases (risk aversion, anchoring, hindsight bias, fear of heights, disposition effect, focusing illusion, etc.). Given the opportunity, System Two will override System One’s error and recognize certain behaviors are historically true and certain heuristics, such as “new normal and “jobless recovery,” are untrue. But is the answer really to extricate all human control in investing decision-making and blindly trust models? Such endeavors have similarly proven catastrophic (Long Term Capital Management, anyone?).
Here, we start to glimpse some flaws in the “two systems” worldview and with behavioral economics/finance generally. First, behavioral psychology really can only “prove” behavior in controlled environments (aka, “experiments”). Application of this stuff in the real world often turns out dicey. A classic example is the work of Richard Thaler and Cass Sunstein (whom Kahneman lauds). Their book, Nudge, which prescribes public policy based on behavioral economic findings, has proven either problematic or outright wrong in the real world. That’s because studying relative utility (how people determine value and the study of hedonics) simply isn’t going to lend itself easily to simple heuristics and prescriptions.
So, we must realize Kahneman’s metaphor for the mind is, at root, a theory. An important one—one that’s given us language and categorizations for problems with mental life versus our intentions. But there will be other theories—and better ones. Behavioral economics is an important force in modern economic thought—but its scope is neither comprehensive nor coherent enough to actually replace economics extant.
Will Thinking, Fast and Slow make me a better investor? I don’t wish to fall prey to any of the many cognitive errors Kahneman identifies, so hopefully. (Oops—optimistic bias.) Pausing a bit to think about what we do—to be more self-conscious—may be the most pragmatic advice Kahneman provides, admonishing readers: Recognize the signs you are in a System One mine field, slow down and ask for reinforcements from System Two. Another way to say this: Be deliberate; be thorough; be aware.