Behavioral economics, the social science founded by psychologist Daniel Ksahneman and his partner Amos Tversky, has had many profound insights into the decisions made by not just investors but the sort of small-bore economic choice we make every day. Kahneman’s best-selling new book, Thinking Fast and Slow, moves away from behavioral economics to focus more on the way we think about everything in our lives, yet its principles apply to investing decisions as well.
The “fast” and “slow” in the title of Kahneman’s new book refer to our two methods of thought. System 1 is quick and intuitive, and can never be switched off; it’s the mode of thinking that’s in constant use for us. System 2 can be long and difficult, and requires a great deal of our attention, which means it tends to let System 1 take over most of the time. One way to illustrate how it feels to use System 2 is to solve a complicated multiplication problem, like 17 times 24, that demands all of your focus. “You could not compute the product of 17 x 24 while making a left turn into dense traffic,” Kahneman notes, “and you certainly should not try.” It’s easier, for most issues that confront us, to let that fast and easy System 1 do our thinking for us.
But obviously, System 1 thinking needs some help when we’re making serious, long-term decisions. Kahneman tells the story of a CIO at a financial firm who had just decided to make a multimillion-dollar investment in Ford stock. His rationale was that he had just attended a car show and was very impressed with Ford’s new line of automobiles. The investment officer was not ashamed to admit he had gone with a gut feeling.
“I found it remarkable that he had apparently not considered the one question that an economist would call relevant: Is Ford stock currently underpriced?” Kahneman writes. “Instead, he had listened to his intuition; he liked the cars, he like the company, and he liked the idea of owning its stock. From what we know about the accuracy of stock picking, it is reasonable to believe that he did not know what he was doing.”
Kahneman believes that the CIO was simply taking the easy way out. Thinking carefully about a long-term investment decision requires a lot of our time and mental energy, and it’s not exactly a fun process. “The question that the executive faced (should I invest in Ford stock?) was difficult,” Kahneman says, “but the answer to an easier and related question (do I like Ford cars?) came readily to his mind and determined his choice.” Kahneman makes that case that this is not unusual, that our System 1 thinking is far more influential than we give it credit for, even in huge decisions like a major investment.
That might help explain why so many people, left to their own devices, often make such poor investment decisions, even poorer than can be explained by random chance. Kahneman discusses the research by Terry Odean, a finance professor at the University of California, Berkeley. Odean looked at the trading records for 10,000 individual investors and found that the shares these investors sold consistently did better than those they bought. The margin was substantial, 3.3 percentage points a year.
Why did this happen? Odean found that individual investors want to shed their winners to take their profits, but often hang on to their losers in hopes of a rebound. The theory is that too many investors let their System 1 thinking dominate: They tend to buy stocks of companies that have recently been in the news, while professional investors tend to incorporate those news reports into their System 2 thinking.
Although the CIO who bought Ford was a professional investor, he fell victim to this effect, Kahneman writes. “System 1 works with as little or as much information as it has,” he says. “If it can’t answer the question, ‘Is Ford stock a good investment?’ it supplies an answer based on related but not really relevant data, such as whether you like Ford’s cars.
Even people expected to have a reasonable grasp on the future of the economy failed to predict where the market was headed. Kahneman discusses a study conducted by Duke University, wherein the chief financial officers of major American corporations were asked, over a series of years, to forecast where the S&P 500 would finish up at the end of the year. They found that the forecasts were no different from random chance; the CFOs basically had no idea whether the market was going up or down.
The kicker to the story is that those same CFOs were also asked to describe a confidence interval, a range in which they thought the S&P 500 would fall within an 80 percent degree of certainty. The CFOs grossly overestimated their ability to forecast the market.
None of us, even financial professionals, truly know which way the market is headed. The best we can do is set aside those gut reactions, and do the heavy lifting of really thinking about what’s best for our portfolios.