Daniel Kahneman is a Nobel Prize awarded psychologist , most famous for his work on the psychology of judgement and decision making.
Thinking Fast and slow tells about how a human mind thinks. It has great implications for investors. This article has a perspective with respect to the investors and what goes in decision making while investing.
Introducing the 2 systems
There are two systems that the author has proposed. These are explained as system 1 Fast Thinking and system 2, Slow Thinking.
System 1 : Fast Thinking
Is automatic, quick and acts with little effort. It is active and most times, maximum people are acting and taking decisions with system 1.
System 2 : Slow Thinking
Requires effort when certain stimuli activates it. You can also say system 2 is about critical thinking, analysis, diagnosis etc. etc. It’s a great diagnostician but it is LAZY, it tries to save its energy and in most cases does not want to act but for better decisions we should know we need system 2 to be active.
Problem usually comes when system 1 affects system 2 in unfavourable way or when system 2 is completely left out while making decisions.
Here are the few biases that we experience in life.
The Priming Effect
When you are talking about a certain topic , the background information is primed into your system and affects your decision making process, impacting the system 1.
Implications For The Investor
Running for the exit door during market crashes is one of them. The financial news asking us to get out of the door is hard to ignore. There is data but you do not know the credibility and other factors that are associated with it when you hear the news of the crash. Those who quickly take the decisions to move out when the market crashes are acting from System 1 because System 2 would go for analysis and diagnosis. This is priming effect and the two systems working .
Now if the system 2 is working, it will take data and analyse it diagnose it from multiple sources before reaching a conclusion of moving out or staying with the stock.
Hasty decisions are decisions of system 1.
The Anchoring Effect
When certain numbers or information is highlighted, and when you do not have enough information about the subject then it changes your thinking pattern to think around that information even when it may not be accurate. It anchors you to those numbers or thoughts.
Example of this is when you see price tags which has INR 5000 strike off and written now available for only INR 1999, your brain gets anchored that the product costs 5000 but now you get it for 1999 which is a great deal but in reality it might just be a trick to get you to buy.
Implications For The Investor
Anchoring is a bias that affects us while making investment decisions as well. For example if you are given stocks of a company for 3 years and in year 1 it was $30 and now it is $10 and you are asked is tis stock cheap, your answer just by looking at this data or the graph might be yes this has fallen from $30 to $10 so this is cheap, but this is your system 1 acting in isolation. This is anchoring. You have to compare it to the other market players in the same sector and also to figure out why the stock is cheap, what factors are responsible. This diagnosis will answer whether you should buy or not.
The Framing Effect
Different ways of presenting the same information evokes different emotional responses and this is how some people get a deal done and some struggle.
Implications For The Investor
Annual Reports of any company is important and gives us a way to know if it is worthy of investing in. However, they are subject to a lot of framing bias. Example the executive might have mentioned there , Attention ! New Records : Our Revenues are up by 12% . This information when scanned through system 1 can lead to a major bias and make us feel this company is doing well. But on further diagnosis, example what about earnings ? You find earnings are down by 20% and there you go, you know just looking at the headline which was in bold asking you to pay attention wasn’t enough, it was important to go through the details.
Another example, you find another annual Report saying, New Records, revenues are up 12%, Profits are up 15% and this is the best growth so far. Is this data enough ? This is probably not the whole story because when we find out how is the market doing, we find out market is growing faster than the company is and thus they are losing the total market share, which is now a complete picture and is not as glittery as it seemed looking at the headlines.
Conclusion : A number or a statement without a proper context can sound very persuasive due to its framing effect but it needs evaluation and we should not leave the diagnosis and analysis in such case.
Cognitive Ease/Substitution Effect
When faced with a difficult question for which simple solution is not available, intuition has a chance but is it a precise answer ?
The author says you can trust your gut when it comes to investment decisions but you need data to back it up. The reason is because your gut or intuition replaces the complex question to a simple answer which does not have a data backing.
Key Takeaways From The Book
1. Hindsight Bias : We have biases like, memory distortion, inevitability, foreseeability and these have consequences. The hindsight bias makes you repeat mistakes because it brings in the intuition factor in play. Now how do you overcome it ? You should keep a log and analyze data over time and go by the facts than going by what you feel is forseeable or inevitable.
2. Overconfidence : Though confidence is a very desirable emotion, overconfidence can be detrimental to investment decisions. Data Points are important, management and team involved in business is important, and so always keep your data clear.
3. The Sunk Cost Fallacy : Most common mistake made by investors. Its so difficult to give up on a stock which is not performing well. If you suspect that it is going down and will further go down even if historical data shows a bright picture, you should consider future prospects and sell.
4. Availability Heuristics : Some events look like they are happening a lot more frequently and that creates a bias. Dramatic events or personal experiences that have an impact can create bias in our minds. For example a loss to a friend in stock market during a crash might create a bias in your head that this can occur to me, overlooking the data at that point.
Implications in the VC world
In the Venture Capital world though everything is governed by data alone be it investments or the future probability of success of an idea, while investing into early stage startups the VCs do not have/ have very little access to financial data at hand. In such a case it becomes so important to not let biases govern the decision making and that is where experience and market knowledge of trends and demand come into picture. A VC’s job is about picking the right companies in their portfolio for maximum returns. The challenge always is that you are putting your bet on companies/ideas which are not in a mature state but a nascent stage or growing stage and though every factor is monitored we still see 8 out of 10 startups not making it and withering away. The key here is to have a strong system 2, thinking slow and to be aware about the biases that may have an impact on decision making.
This is also the reason that VC’s prefer to meet founders who already have an MVP and some traction and revenues in place. It gives them some data to understand the future graph. Having said that such an early stage data is no guarantee for the future trends and thus all factors have to be modeled in always before these decisions are taken. Sometimes we have seen even after 3-4 rounds of funding and some minimum initial revenues the startup dies off.
Intuition is system 1, if backed by diagnosis and analysis which falls in system 2, we can expect better judgement and decision making.
I hope this article was helpful in understanding the way we think and would help you make better informed decisions.
Do leave your comments below and I shall try and answer your queries.
Rise and Shine
Hurratul Maleka Taj
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