Nobel prize-winning economist Daniel Kahneman published his best-selling book Thinking Fast and Slow in 2011. The lessons he shares about how people make decisions have influenced many professions and sectors, including the financial world. Here’s how fast and slow thinking applies to investing, and five biases you need to look out for if you want to make better decisions when it comes to your investments.
What is fast and slow thinking?
If you’re new to Kahneman’s concept of fast and slow thinking, here’s a quick recap.
The human mind is wired to process information in two ways. The first, which Kahneman calls “system 1 thinking” or “fast thinking,” uses intuition and emotion (the “gut”) to evaluate information and make decisions. The primary advantage of system 1 thinking is speed, and it serves us well when it comes to survival. We don’t have time to sit around and logically weigh the costs and benefits of a particular course of action when we’re being pursued by a tiger.
“System 2 thinking” (slow thinking), on the other hand, is rational, linear, abstract and comprehensive. System 2 thinking is also hard work. Too often, we take the easy way out and rely on the biases and automatic thinking of system 1 to feed information to system 2. The result is faster, but it can lead to flawed decision-making.
How does fast and slow thinking apply to investment management?
When it comes to investments, many people believe that they’re making rational, carefully considered choices. The consequences of investment decisions are just too important to leave them to fast, biased, overly emotional system 1 thinking, so we must be using system 2 thinking. Right?
Instead of consulting credible sources, gathering all the evidence, weighing it and making impartial choices that we believe will lead to the highest financial gain, we often make our investment decisions based on shortcuts, biases and feelings.
This is true of individual investors who are buying and selling stocks and ETFs or giving direction to their financial advisors. It also applies to investment committees who must evaluate the results achieved by their advisors. And it sometimes applies to the advisors themselves, unless they have the proper processes in place to prevent it.
Portfolio managers—who are held to the highest standards in the financial industry—understand that using system 1 thinking is a risk in investing. They guard against it by following a rigorous investment process that relies on quantifiable data and can be replicated. This helps to ensure that historic results provide some insight into how the manager’s strategy may perform in the future and reduces the chance of biases hurting your results.
This article is based on Risk, Financial Markets & You: Your Guide to Making Better Financial Decisions, a book by Adaptive ETF strategist Alan Fustey.
5 biases that are hurting your investment decisions
There are a number of mental shortcuts or rules of thumb (psychologists call them “heuristics”) that our system 1 brains use to make our decision-making faster and easier. If you make financial decisions, you’d be wise to know them well, recognize the signs that you’re using them and know what information to use instead. We cover five of the biases in this article, and five more biases in part two.
#1: The most easily recalled information is the most relevant
Signs of bias: You’re allowing yourself to be swayed by just-released information, especially “breaking news” from 24/7 news outlets. You make decisions based on emotional personal experiences.
What to do about it: Dig deeper. While you shouldn’t discount the information and experiences that pop to mind first, do the hard work of seeing them in the context of other information that may not be so top-of-mind.
Also called the “availability bias,” this shortcut uses the examples that spring to mind most quickly to judge whether information is important or something is likely to happen.
The most easily recalled examples are often the most recent. For example, you could be relying on a news story that just broke or a financial article you just read to guide a financial decision. Easily recalled examples are also often the most emotionally powerful. Did you have an elaborate daydream about making big gains on an as-yet unpurchased investment? Did you experience real-life losses during a market downturn? Both conjure up strong feelings, and can influence your decision-making.
#2: Things that seem similar must be related
Signs of bias: You’re making investment decisions based on stereotypes and assumed relationships between things rather than statistical probability.
What to do about it: Know the basics of statistics (or hire a portfolio manager who does) so you can more accurately determine the probability of something. Be on the lookout for evidence that goes against your stereotypes.
This shortcut, called the “representativeness bias,” assumes that two things that seem like they belong together are causally or statistically related. For example, you could assume that a company that makes high quality clothing would also be a high quality investment, even though the quality of a company’s product may have very little to do with its value in your portfolio. Or you could assume that a stock whose value has declined for 10 days won’t continue to decline further, so you should hold onto it.
#3: Things that make you feel good are good (and things that make you feel bad are bad)
Signs of bias: You’re making investment decisions based on how you feel about a company, sector or country rather than on factual information. You consider risk to be lower at times when you feel good.
What to do about it: Be wary of “the buzz” around an investment and instead look for objective evidence of risk and benefit. Ask yourself how you feel about an investment opportunity and consider whether those positive or negative feelings are influencing your decisions.
This heuristic is called the “affect bias.” Humans want to keep associating with things that make us feel good and avoid things that make us feel bad. When it comes to a mother’s love (good feeling) or a tiger’s roar (bad feeling), this bias is helpful. When it comes to investment decisions, however, it’s not a reliable way to judge value. It’s no coincidence that morning sunshine is associated with positive stock returns—people feel good when the sun shines, which influences their perception of risk. But sunshine isn’t a good reason to take a risk, is it?
#4: You overestimate your abilities
Signs of bias: You trust yourself more than anyone else. You’re often surprised by the results of your decisions. You believe you’ll make money, if for no other reason than you’re the one in control.
What to do about it: Seek out information and advice from others whose education and experience make them more qualified than you to recommend a course of action.
Pride comes before a fall, but that doesn’t seem to stop many of us from hitting the ground hard, time after time. That’s because of the “overconfidence bias,” which is responsible for our belief that we’re better than our peers. This belief leads us to overestimate our abilities and underestimate risk.
#5: Hindsight is 20/20
Signs of bias: You find yourself explaining events in the past, such as a market downturn, rebound or correction, as if you knew it was going to happen, even though you didn’t actually take action on that intuition.
What to do about it: Recognize that it’s human to dislike uncertainty. Pay attention when you predict future outcomes based on what happened before.
The "hindsight bias" explains our tendency to believe that a past event was entirely predictable simply because we already know the outcome.
This bias comes from our discomfort with randomness and uncertainty. We don’t like the idea that the future is unpredictable, so we pretend we can tell what will happen because we know what happened before. Anyone involved in financial decision-making knows the past isn’t a reliable predictor of the future, but thanks to the hindsight bias, somewhere deep down we wish it was—and this can make us overconfident in our ability to predict the market or pick winners.
Let’s recap the main points we’ve covered.
First, humans have two ways of thinking: fast and slow. Fast thinking, which is reactive, uses mental short cuts to speed things up. We rely on information that’s top of mind (availability bias); make connections between things that aren’t necessarily related (representativeness bias); mix up feelings with facts (affect bias); think we’re better than we actually are (overconfidence bias); and assume we can predict the future simply because we know what happened in the past (hindsight bias). Unfortunately, these biases can affect the quality of your important decisions, including the what, when, where, why and how of your investments.
If you’re interested in learning five more biases that could be hurting your financial decision-making and what to do about them, read part 2.
Has bias hurt your investment decisions? Let's find out.
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