My first foray into the financial markets came in the summer of 1985. I somehow secured an internship working for one of the smartest people I have ever known at a regional brokerage firm in Memphis, Tennessee. My boss and I were transplants from California — strangers in a strange land — and we had a ball.
One day, one of the old-timers in the firm — someone referred to as a “bond daddy” — took me aside and asked me to explain the firm’s strategy for derivatives. I made my explanation as simple as I could, but he was dissatisfied. Finally, he stopped me and said in his deep Memphis drawl, “Son, you need to understand one thing. I may talk slow, but I don’t think slow.”
“Thinking Fast and Slow” is the title of an excellent book written by Nobel Prize laureate Daniel Kahneman. Kahneman received the 2002 Nobel Prize in economics for his work on something called “prospect theory,” an interesting confluence of economics and psychology. In the following years, Kahneman broadened his research to examine other cognitive biases in our economic lives.
According to Kahneman, we all have blind spots in our thinking, though most of us are unaware of them. The following experiment illustrates this.
Consider these facts: “Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination, social justice and also participated in anti-nuclear demonstrations.” With those facts in mind, which is more probable: 1) Linda is a bank teller or 2) Linda is a bank teller and is active in the feminist movement?
If you chose option 2, you are part of the overwhelming majority who got it wrong, including 85% of students in Stanford’s Graduate School of Business. Think of it this way: feminist bank tellers are a subset of all bank tellers — so the probability of option 1 must be greater.
This is only one example of how our rational, analytical brains can get hijacked by our cognitive biases. It’s not emotion clouding our judgment, but an intermittent bug in the way we think.
Here’s another example: a bat and a ball cost $1.10 and the bat costs $1 more than the ball. How much does the ball cost?
If you said 10 cents, you would agree with the vast majority of respondents. But you would also be wrong. The correct answer is 5 cents. Doing the math makes the answer obvious, but most of us miss it at first.
According to Kahneman, these kinds of cognitive mistakes result from two types of thinking going on in our brains at the same time, thought processes he calls System 1 and System 2.
System 1 thinking is fast, intuitive and often unconscious. It allows you to safely drive from point A to point B with little recollection of the journey. System 1 thinking applies existing patterns of thought to new information, instead of letting the new information speak for itself. If you got either of those thought experiments wrong, it is probably because your System 1 brain had taken over.
System 2 thinking, on the other hand, is slower and more laborious. It consciously weighs facts and analyzes outcomes. It notices details that System 1 skips. But System 2 brain activity is energy-intensive. It takes real work. To conserve energy, our brains sometimes let System 1 take over when we really need to use System 2.
When consequences from mistakes are small or inconsequential, a fast System 1 response may be good enough, even if it isn’t perfect. But System 1 thinking in financial decisions can result in serious and expensive, errors in judgment.
As you proceed along your financial path you will face many difficult decisions: How much do you need to save? When should you take Social Security? How should you pay for healthcare? What’s the best rate of withdrawal from your IRA? How should you invest your portfolio? Do you need long-term care insurance? How will you pay off your mortgage? To navigate this path successfully, you must resist the urge to fall into the System 1 trap. Slow down, take a deep breath and let your System 2 thinking be your guide.
Steven C. Merrell is an investment adviser and partner at Monterey Private Wealth, Inc., in Monterey. Send questions concerning investing, taxes, retirement or estate planning to Steve Merrell, 2340 Garden Road Suite 202, Monterey 93940 or steve@montereypw.com.
