Understanding the Role of Our Dual Thinking Systems in Our Investment Decisions
The Two Systems
The foremost task in equity investing is to make accurate judgements about a stock’s prospects. We buy stocks with good prospects; we avoid or sell those with poor prospects. In this regard, it would be instructive to be aware of how our mind operates and makes judgements. According to psychologists, our mind has two modes of thinking: slow and fast. Both have distinct personalities, abilities, and limitations. Normally, we identify with the slow-thinking system (psychologists call it, System 2). Still, most of our life’s judgements, actions, and behaviours are guided by the impressions generated by the fast-thinking system (System 1): a fact many of us are unaware of.
System 1 is an automatic system that operates, continuously and effortlessly, trying to make sense of the world and looking for immediate threats or opportunities in our environment. Meanwhile, System 2 is deliberate and effortful; it operates only when its service is called for, otherwise, it stays in a minimal effort state; it requires mental effort to operate; and can perform much more complex computations than System 1. However, it is so lazy that it tries to evade effort wherever possible. System 2 computations happen consciously and require mental effort, unlike system 1 computations which happen effortlessly and unconsciously.
When things are going smoothly (most of the time), system 1 dominates our mental functions. However, system 2 is mobilised if system 1 (the automatic system, the intuitive mind) doesn’t have an answer to a situation or detects a stimulus in the environment that conflicts with its model of the world.
System 2 (the deliberate system, rational mind) requires mental effort to function and induces cognitive strain. However, to live our entire life intentionally guided by System 2 is implausible and miserable. Also, we don’t want to burn our limited mental energy by engaging our effortful system 2 on trivial matters. In other words, we don’t want to mobilise system 2 for tasks our system 1 can perform well. However, as System 1 is prone to serious logical errors, System 2 should be mobilised to guard against these errors, particularly in high-stakes, uncertain situations: judging a stock’s investment prospects fall into this category.
However, System 2 wouldn’t be mobilised if System 1 judgement seems right. Our mind aims to achieve its goals through minimal effort; therefore, the quick, automatic, and effortless judgements of system 1 are always preferred over the slow, deliberate, and effortful judgements of system 2. However, in high-stakes situations, we should intentionally mobilise System 2; first to resist the impulses of System 1 impressions, and later to rationally evaluate the situation independent of System 1 impressions.
In the mind’s normal course of working, system 2 is activated only when system 1 is surprised or feels threatened. Otherwise, system 2 endorses the first impressions of System 1 (system 2 is lazy). Therefore, activating system 2 when everything seems to be going smoothly requires intention. This applies to reviewing our investment portfolio.
If the overall portfolio and its constituent stocks are doing well, we are relaxed and cognitively at ease. We don’t find the need to employ a system 2 effortful evaluation of portfolio risk and prospects. We are willing to question our judgements, conclusions, and assumptions only when a sharp drop in prices or something similar induces strain. But since these realisations come belatedly, adverse impacts on investment performance would have already ensued. Moreover, the consequent emotional damage could imperil later effective system 2 functioning.
Periodic and systematic evaluation of investment portfolio by intentionally activating our effortful system 2 is imperative for long-term investment success.
Impressions
The automatic system (system 1) continuously evaluates the environment for possible threats or opportunities. If the evaluation finds the environment good, safe, and favourable, we experience cognitive ease and a good mood. Conversely, we enter a cautious mode, characterised by cognitive strain and unpleasant mood, if the automatic system recognises something new, unexpected, or unfamiliar in the environment.
Unlike the continuous computations of the automatic system, the deliberate system’s (system 2) computations happen only when the situation necessitates it. However, even if such a situation arises and the ‘deliberate system’ is activated, the first impression made by the ‘automatic system’ through its basic assessment would already be available. These impressions could substantially influence the deliberate system’s computations.
My choice of a stock to analyse is based on the impression generated by the automatic system from a glance at the stock’s price chart, financials, and valuation. A positive cue is a ‘go ahead’ signal. Such quick judgements are essential to navigating an equity market of more than 4,000 actively traded stocks. Though convenient, how effective such quick judgements are is questionable. However, such quick judgements are used to choose a stock to analyse, not to invest. The final decision to invest or not is made only after a systematic and careful analysis by the deliberate system.
The impression made by the automatic system through a simple assessment (quickly and automatically) could, however, influence our final investment decisions. Our decision to employ our deliberate system to analyse the investment prospects of a specific stock is based on the positive emotional cue triggered by the basic assessment made by the automatic system. Sometimes the emotional cue would be so intense that we might see favourable prospects, despite a more thorough analysis by our deliberate system suggesting otherwise. Here, our intuitive judgment and rational judgment differ, and we are compelled to choose the intuitive judgment over the rational judgment due to the intense emotional cue associated with the intuitive judgment.
Only informed judgements are accurate. Intuitive judgements about something we know very little about would be highly inaccurate. However, according to Kahneman in ‘Thinking Fast and Slow’, “the normal state of our mind is that it has intuitive answers and opinions about everything that comes our way.” It is because of an illusion of understanding: although we know very little about something, we think we know a lot about it.
Familiarity, Similarity, and Liking are usual culprits behind this tendency. A statement we have been repeatedly exposed to becomes familiar; anything familiar feels good and true for the automatic system. An engineering graduate may develop a special affinity for stocks from the engineering sector; the automatic system is prone to misinterpret the liking for understanding. We are prone to see favourable prospects for a stock whose products we like, although our liking is unrelated to its investment prospects. Suppose a present situation shares one or two common traits with a past situation. Once the automatic system detects the similarities, it quickly concludes that the two are identical, which causes us to believe that we understand the present situation well.
Familiarity, similarity, and liking; are qualities that underlie many of the quick impressions made by our mind’s automatic system. Making accurate judgements about a stock’s prospect is a complex task requiring deep and extensive computations and interpretations, something only our rational mind (deliberate system, System 2) can do. However, despite intentionally employing our rational mind (deliberate system) in the situation, the first impression made by our intuitive mind (automatic system), could still sway our decisions. This might not be a problem if our rational judgement agrees with our intuitive judgement; the problem arises when they disagree.
We might then forego our rational mind’s judgement made through extensive logical reasoning for the intuitive mind’s quick, automatic, and effortless judgement. This erroneous tendency depends on the intensity of the feelings that the first impression induces. The more intense the emotions, the more likely we are to choose intuitive judgements over rational ones. We are wrongly associating the emotional intensity of the situation with our understanding. The more intense we feel, the more we think we know.
I can think of a few situations where I decided to go by my intuitive judgements due to high emotional intensity, despite a sceptical rational mind. The outcomes of such decisions have largely been pathetic; I regret making most of those decisions. Unfortunately, regret and the realisation that caused the regret always come belatedly. The most deceiving aspect of the emotionally intense intuitive judgement is that they feel so correct at the time.
Emotions are transient; their energy dissipates gradually. Devising effective coping mechanisms to resist impulses until the emotional energy dissipates could, to a certain extent, help us overcome the compulsion to override our rational judgements with our intuitive judgements.
Intuitive judgements are not useless and harmful in every situation; we need them to navigate this world. If a kid accidentally jumps in front of our driving car, there is no time to deliberate over the best course of action; the decision to apply brakes happens (or should happen) intuitively. We need intuitive judgements to guide us in situations that demand an immediate response. The trouble is when we use our intuitive system on complex tasks that require deep thinking and extensive deliberation.
Effort
If there are several ways to achieve a goal, we habitually choose the least effortful rather than the most productive one. It is no different for investing matters, like, where to invest our money or which stocks to buy that would maximise our return.
This tendency towards a less effortful path might be the reason for the prevalence of several fraudulent financial schemes that promise exorbitant returns but largely swindle naïve investors. These schemes project irresistibly high cost-benefit ratios and all that investors need to do is follow the easy path suggested by the schemers. The investors might be thinking: why should we inculcate analytical skills and put strenuous mental effort into something available much more easily and effortlessly?
Despite their previous experience of losing money in such schemes, investors never stop falling prey to more such schemes because the alternative of acquiring skills and employing mental effort is too alien and discomforting for them. Even for someone willing to put in the necessary mental effort to achieve his investment goals, where to put in the effort is a perplexing issue.
Holding and processing information about the 4,000 or so stocks that are actively traded daily on Indian equity markets is way beyond the mental capacity of any of us. Once we reach the peak of our cognitive capacity, we resolve this issue by becoming selective: we pay attention only to matters we believe to be important.
Where we employ our mental effort is consequential to our investment outcome. If we don’t consciously deliberate, our intuitions and impulses will decide where our skills and efforts will be employed. Most investors are unwilling to put in the necessary effort and those willing don’t use it productively. If they had been, we wouldn’t have such a low success rate in equity investing.
The amount of information generated in a month or year has grown exponentially over the past few decades while the human capacity to process and make sense of this information has stayed the same. Our mental system deals with overload by being selective. Usually, in such situations, our impulses and intuitions prioritise and decide where our attention gets engaged. That is unlikely to be in our best interest.
Naïve investors are largely presumed to be driven by impulses and professional investors by their intuitions. However, both have their shortcomings causing investors to miss out on the most important and relevant matters. Most of our judgements are guided by our impulses and intuitions as they are quick, automatic, and effortless. Although our rational mind can make better or less erroneous judgments, we are less likely to activate them because that involves mental effort. Therefore, even if activated, the rational mind merely accepts the impulsive or intuitive judgement to avoid mental effort.
Our rational mind is usually employed only when we have no other option; this happens when our impulsive or intuitive minds don’t have answers to our questions, solutions to our problems, or judgements about a situation. Our rational mind can consider several relevant facts and perspectives at a time and construct different possible scenarios, all of which are more likely to deliver better judgements.
Effectively employing our rational minds involves three mental tasks: self-control, cognitive tasks, and managing attitude. Self-control enables us to focus on the task without being waylaid by temptations and distractions. The cognitive task involves considering all relevant facts and variant perspectives and rationally judging a stock’s prospect.
If our impulses or intuitions have already made a judgment, we are prone to make wrongful judgments despite employing our rational minds. In such situations, our rational mind is biased, and its efforts go towards constructing a rational explanation for intuitive judgment.
This sort of biased thinking happens only when there is an impulsive or intuitive judgment. Unfortunately, such quick judgements are the default; they are pervasive; hence, safeguarding against biased thinking is essential to achieving our investment goals. This erroneous inclination could be corrected largely by maintaining an incredulous and sceptical attitude towards judgements (the quick ones) emanating from impulsive and intuitive minds.
A sceptical attitude prevents our rational minds from rationalising intuitive judgments. We should try to invalidate the intuitive judgments; only if we fail at them convincingly should the intuitive judgments be accepted. We are more likely to accurately judge a stock’s ‘return prospects’ by employing our rational mind in evaluating the stock’s ‘risk prospects’.
Easiness
Our investment success depends on making accurate judgements about a stock’s prospects. We always prefer to accept the quick judgements of our intuitive mind, not because of their effectiveness but because of their convenience: intuitive judgements happen effortlessly, feel comfortable, and are mildly pleasant. A sense of cognitive ease is inherent in intuitive judgements, unlike our rational judgements which require exerting mental effort and enduring cognitive strain.
Since learning about the concept from Daniel Kahneman’s book ‘Thinking Fast and Slow’, I became curious about how ‘cognitive ease’ might impact my investment decisions and market outlook.
The book says that we enter a state of cognitive ease if our mind finds no serious threats, problems, or unmet demands in our immediate environment. This state is comforting and mildly pleasant; we are relaxed and in a good mood. Conversely, we experience cognitive strain when our mind identifies threats, problems, or unmet demands in our immediate environment. It is discomforting and straining and affects our mood adversely.
Our automatic, intuitive mind dominates our thinking and judgements during cognitive ease; the deliberate, rational mind is more dominant during cognitive strain. Alongside the pleasant feelings, cognitive ease makes us more creative and intuitive. The drawbacks of cognitive ease are that it makes us less vigilant and more gullible; we indulge in casual and superficial thinking; and thus, are highly prone to major logical errors. Meanwhile, although discomforting and unpleasant, cognitive strain makes us more engaged, vigilant, and cautious; we have an analytical approach: major logical errors are less likely if the deliberate system dominates our mental functions.
The problem is determining which of these states – cognitive ease or cognitive strain – is the most effective in generating the insight that would help us accurately judge a stock’s prospects. Intuitively, an analytical mindset (cognitive strain) seems more likely to deliver an accurate judgement.
Our rational mind remains inoperative under ordinary conditions. It is called upon only when the intuitive mind senses a threat, difficulty, or problem in the immediate environment, for which it does not have an answer. Mobilising our rational mind otherwise requires intention.
We are reluctant to intentionally mobilise our rational mind if our effortless intuitive mind has an answer or judgement that feels good, true, or accurate. Moreover, mobilising the rational mind involves shifting from the comfort of cognitive ease to the discomfort of cognitive strain.
Intuition means we know something although we don’t know its source – why we know it or how we arrived at it. An emotional cue always precedes an intuitive answer. We could intentionally mobilise our rational mind to validate the intuitive judgement, but since it involves mental effort, we usually go by the intuitive judgements. Even if we decide to deliberate on the problem, we engage in casual and superficial thinking when in a state of cognitive ease.
The computations of our intuitive mind happen quickly and out of our awareness by associating related information in our perception and memory. Sadly, this is where the major shortcoming of our intuitive judgements lies; any information out of our perception and memory is absent from our intuitive mind’s computations. Therefore, we must be cautious if a judgement or answer comes to us quickly and easily.
We don’t have to reject all our intuitive judgements; however, considering the increased likelihood of mistakes, it would be prudent to validate them by intentionally mobilising our rational mind; and we could mobilise our rational mind intentionally by getting out of our comfort zone.
Limitations
One major limitation of system 1 (automatic, intuitive system) is jumping to conclusions: making quick judgements about a person, a situation, or a stock’s prospects with limited information. It is less concerned about the judgement’s accuracy: if it feels good, it must be right. The good mood, the cognitive ease with which the judgement happens, and the confidence and comfort the judgement impart are misconstrued as signs of accuracy.
It does not matter to System 1 whether the limited information (on which the judgement is based) is relevant to the situation. Only information retrieved from the memory is available at System 1’s disposal to make judgments; moreover, the information retrieved is not based on its relevance to the situation, but on its ability to generate a coherent story. Information relevant but inconsistent or incompatible with the story or even among themselves isn’t retrieved and hence not considered in making the judgement.
Jumping to conclusions requires less time and effort. They could be relied upon if their judgements are accurate most of the time and the cost of occasional errors (if any) is less. Unfortunately, they are observed to have poor accuracy, particularly when stakes are high, in unfamiliar situations, and uncertain and ambiguous situations.
Equity analysis aims to make accurate judgements about a stock’s prospects. When we embark on the task, we don’t have much control over the information that System 1 retrieves from memory. One bit of information could be subjected to multiple incompatible interpretations: it is ambiguous. However, System 1 is insensitive to or unaware of ambiguity. System 1 extinguishes the ambiguity of the situation by interpreting that one piece of information relative to any recent related events or the current context.
Suppose that the one piece of information is a positive earnings surprise. System 1 searches memory for how the stock had reacted to positive earnings surprises in the recent past. System 1 judges the stock favourably if the stock had delivered positive returns in the recent past soon after positive earnings surprises. System 1 will find a way even if no such information is available in the recent past: it will search memory for information about other similar stocks’ reactions to earnings surprises and use that information to judge the present stock.
The stock can also be viewed positively as consequent to a positive earnings surprise if the current market context features rising stock prices and a strong earnings season. However, the same earnings surprise would be treated differently had the current market context been characterised by falling stock prices and a poor earnings season.
System 1’s interpretation of the first information is our first impression. Our final judgment could still be biased even if we resist System 1’s jumping to conclusions due to the significant influence the first impression will exert on later information’s interpretation. Unfortunately, unbeknown to us, the increased weightage of earlier information in the final judgement reduces its accuracy.
The interpretation of each piece of information or evaluation of each trait should be independent. The amount and quality of information (to which system 1 is indifferent) are imperative for accurately judging a stock’s investment prospects. Intentionally mobilising system 2 would be helpful because it can deliberately search and retrieve relevant information.
We usually judge a stock’s investment prospects by evaluating its business economics, competitive position, management quality, cash flow efficiency, operating profitability, earnings trend, and valuation. Relevant pieces of information are those that enable an effective evaluation of the above traits. Additionally, we must evaluate each trait independently to make an accurate final judgement. The usual approach is to analyse a stock’s traits sequentially and make a final judgement. If so the possibility of the first trait’s evaluation influencing the second trait’s evaluation is greater.
One way to reduce such biased judgements is to select at least ten stocks to analyse simultaneously, rather than one stock. Then, instead of evaluating them in the usual systematic manner, do so in the most disorderly manner possible.
Say you first evaluate stock A’s business economics; then, instead of evaluating stock A’s (the same stock) competitive position as usual, evaluate stock D’s (another stock) cash flow efficiency. This way, the chances for the evaluation outcome of stock A’s competitive position to influence the evaluation of its operating profitability are greatly reduced: now there is a distance between them, in time and task.
While interpreting information, System 1 can see only one interpretation and is oblivious to potential alternatives. The interpretation normally feels consistent and convincing; we are usually happy and confident in such interpretations despite their inaccuracies. However, system 2 could construct multiple incompatible alternatives, enabling a comprehensive evaluation of the stock’s prospect.
We are generally less happy and confident with such evaluations, although they might be more accurate than the confident, comfortable, and quick interpretation of System 1. Getting used to a discomforting inconsistency is essential to accurately judge high-stakes situations characterised by ambiguity and uncertainty, such as evaluating a stock’s investment prospect.
Subscribe
Receive our latest content in your Inbox.
AMN CAPITAL 