Last Updated on 10 months by Piyush Jain
Daniel Kahneman is a psychologist, professor emeritus of behavioral economics at Princeton University, and received a Nobel Prize in 2002 for economics. He is most famous for his work on the psychology of judgment, decision making, and behavioral economics. In 2011, Daniel Kahneman (I will further address him as Daniel or the author) released the book Thinking Fast and Slow on these subjects. Thinking fast and slow presents the concepts of how the human mind perceives and analyses its surroundings.
Daniel states that there are two systems system1 and system 2. System 1 is the fast-thinking system to system 2, which is slow thinking. This concept is used in decision making for personal relations, career to investments.
A basic example displaying the working of system1 and 2 is as follows. If a bat and a ball both cost $1.10, and the bat is $1 more than the ball, then what would be the cost of the bat and the ball? On the first thought, the bat would be $1 and the ball of 10 cents. That is the impact of system 1, while if you have implemented your system 2, then the answer would be different. Try it again now. You will get the right answer.
The first system, system 1, operates automatically, quickly and with very little effort. The second system, System 2 allocates attention to mental activities that requires effort when certain stimuli activated. Both systems have been necessary for the survival of the human species. When either system 1 or system 2 are left out of the decision making, then it is not right. System 2 is a sort of very lazy person.
Another example can be when you make a monthly plan to invest and there is an option to automate it or keep it manual. When you keep it manual, your system 1 activates and you may or may not invest regularly. You achieve your financial goals when the deduction is automated as System 2 is working. One is lazy and one does not cancel the same. This is where one has used system 2 to his advantage.
6 Psychological Effects for Decision Making
Priming is an excellent technique where people tend to behave based on the current discussion between them. A good example is if one talks of old age with the group of students, and they have to pick up an assignment from the room at the end of the corridor, then they tend to walk slowly, imitating the old age. They walk fast, imitating liveliness and youthfulness when discussion topics are related to youth and liveliness.
In the same manner, if there is a panic in the market crash and media cries of the bearishness in the market, people will start exiting the market and do panic selling. This is their impulse of System 1, while the people who are calm and composed, they will think and maybe do buying, or keep themselves on hold. They are using their system 2. One can’t avoid being primed by the media, friends, and the discussions around.
Next example, think over what would be the tentative answer for this question without using any search engine. 1) There are more or less 16 Americans for every Norwegian National. 2) Can we fit 44 Norway in the total area of the US? What is your answer?
What is your answer? For the 1st question, the answer is 56 American for every Norwegian. Now that is on the higher side, so when you think about the area, it would be on the higher side, while it is 25 Norway required to fit in complete US. Why were we forced to think on the higher side? This is the anchoring effect.
Retailers use this technique now and then. Whenever we buy something from the market which we have not researched on, the price initially stated will have anchoring effect on us. If one says that the dress is of $1000, and gives you a discount of $200, you will be happier to get that discount. While this dress may be of at most $500.
There is another situation, where a stock of a company has fallen to $100 now, while its peak in the year was $300. Should you be buying it in the fall time, as it appears cheap? Based on the anchoring effect, this would appear cheap. But NO. You need to think over, look at the fundamentals, the reasons, and then decide. There should be a reason that a stock is down, while the general market is up, before taking the decision.
Now evaluate 2 situations.
- You have been exposed to a disease leading to certain and painless death. In seven days, the risk of you catching it is one in 1000. How much would you be willing to pay for a vaccine that will cure you? There is no way to know if you have caught the contaminated.
- Volunteers are needed for research on a new drug. But there is a risk that you catch a deadly disease. This happens in one out of a thousand trials. The disease is painless, but you will suddenly die in seven days. If you catch it, how much money would you demand to participate?
Most people demand a much higher payment in situation B than they are willing to pay to cure themselves in situation A. Reportedly, subjects tend to demand 50 times more for the second than the first, although from a mathematical standpoint they are identical. They are both answers to the question how is a one in a thousand probability of dying in seven days?
The difference is that the situation A states the problem in a manner that the issue is more of a luck issue, while situation B states that the issue is related to the research. Therefore, in situation B people demand more to be the part of the research.
There can be a similar situation in annual report of the company. How do they state it. Company A may state with happiness that their revenue increased by 20% YoY. When we dig deeper into profits; well that has decreased by 15% (due to increase in business expense or whatever may be the reason.)
Company B stated with happiness that their profits increased by 20% YoY. When we dig deeper into profits; well that is true, but competitors have their profit increased by 30% or more (as they did more in the expanding markets, and this company could not).
The learning is that the number or statement without its proper context can sound persuasive. Any investment decision must carry a fair amount of thinking gone in it, to check out sound management and fundamental principles for the company to do good. Do not get framed.
Regression to the means
Daniel gives the outcome of the decisions which we take on the basis of our intuitions. For example, if we take mutual funds which are doing very good. They may continue to do good for a while. But for how long? They may dip further because of the following.
- When the fund is too heavy then keeping over the market or fighting the downfall is not easy.
- Someone may hire the fund manager and leaving the fund orphaned.
Therefore, one should limit the expectations on the returns, based on luck and market movements. This is neither an indication that bad performing funds will rise later.
Learning from Hindsights
One does not remember why one took certain decisions, so do not know what should I be doing now. In this case, the author suggests that one should keep a log of the reasons for the major decisions one takes.
Never invest based on confidence and intuition. Market will always take advantage of these sort of investment decisions. If one must invest in the stocks, they should check if fundamentals and prospects of the stock is good. If one can use system 2 then only invest, else remain within the mutual funds area with safe investments, using system 1.
Sunk cost are the costs that won’t returnback. Your future decisions should not be based on them.
To state an example, one is in a bar and there are 2 situations
- The bar is going to close. Bartender announced that its 3 AM and only last round will be served. You order one more. The time, when the order is served, you are completely drunk. What will you do?
- a) Have the drink as you have spent on it.
- b) Leave the drink as it may not be nice for you further.
- The bar is going to closed, while you are still drinking. The bartender offers you “on the house” drink. You are completely drunk. Will you
- a) Have the drink as it on the house.
- b) Leave the drink as it may not be nice for you further.
In case you answered a for situation 1 and b for situation 2, then you have fallen for the sunk cost fallacy. You should not be taking further decisions only based on the money spent.
Victim of the Availability Heuristic
If someone has burnt his hands in situations like exploitation at school, loss in the stock market, or a relationship, then it is very difficult to convince him. Though one may see that inverse is happening, the person will be scared of the same happening again.
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