When it comes to investing, is it better to think fast, or slow?

When it comes to investing, is it better to think fast, or slow?

What type of investor are you? When you make investment decisions, do you rely more on ‘gut feeling’, or analysis? It’s an important distinction. Because understanding the way you make decisions – fast or slow – can help you make better ones.

These two ways of thinking are labelled by Nobel Prize winning psychologist, Daniel Kahneman, as system 1 and system 2:

• System 1: This is your gut reaction – where your cognitive biases tend to be stored.
• System 2: This is your analytical thinking – the system that makes spreadsheets and solves maths problems.

They each have a distinct function in our lives – however there are times when using the wrong one is dangerous.

System 1 is by no means all bad. It’s the system we use most – it’s effortless and generally makes decisions before we’re even aware of them. What’s more, most of the time, system 1 is correct, even though we don’t instantly understand why.

The writer and social researcher, Malcolm Gladwell, illustrates several examples where system 1 is better than system 2. Here’s two examples that stand out to me:

• A firefighter in Cleveland evacuated his team from a routine kitchen fire. Moments later, the floor of the building collapsed. It took him two hours of questioning to identify how he drew the correct conclusion to evacuate his team.
• In 1983, the J. Paul Getty Museum purchased a kouros, following a 14-month investigation on its authenticity. However, art experts who later saw the sculpture ‘instinctively’ identified that something “seemed wrong”; they turned out to be correct – the sculpture was, indeed a fake.

Both of these examples illustrate effective use of system 1. The intuitive feel that came instantly was better than processing and analysing the full set of information. Why?

System 1 relies a lot on pattern recognition. It essentially uses ‘heuristics’ and past experience to jump to conclusions. It’s the part of your brain that identifies a glare as uncomfortable, or goes into autopilot as you stroll down the road. It is very good at judging simple, repetitive tasks – like where the potholes are on your drive home. It’s a lot worse at identifying surprising new information. It’s also very bad when it comes to being biased (here’s four blogs on system 1 breaking down: one, two, three, four).

Daniel Kahneman sums it up well:

“Jumping to conclusions is efficient if the conclusions are likely to be correct and the costs of an occasional mistake acceptable, and if the jump saves much time and effort. Jumping to conclusions is risky when the situation is unfamiliar, the stakes are high, and there is no time to collect more information.”

The problem is, in finance, the situation is often unfamiliar, the stakes are high, and as long term investors there is ample time to collect more information. Hence a conscious focus on engaging system 2 thinking is critical to successful investing. System 2 can process complex environments, question conclusions and analyse new data. It requires effort and is prone to error if rushed (in fact your brain switches automatically to system 1 when under time pressure or stressed – which makes practising mindfulness worthwhile).

So why did system 1 work so well in Gladwell’s examples? For the first example – the answer is two-fold. Firstly, given the time pressure, system 1 is more necessary. In the time-frame, resorting to statistical analysis wasn’t possible, the firefighter was forced to rely on intuition. Kahneman outlines that experts are most useful in the presence of two conditions: (1) an environment that is sufficiently regular to be predictable (2) the expert has learned these regularities through prolonged practice. Notably, both of these conditions were met in Gladwell’s examples. The firefighter had spent years fine-tuning his gut response to fires (or thin-slicing the relevant information as Gladwell calls it). Similarly, the art experts had spent thousands of hours understanding different artworks to fine-tune their pattern recognition.

So why did system 2 work so poorly in the second example? The reason is system 2 is error prone. The 14-month analysis missed key details which led the investigation to the wrong conclusion. Having incomplete information can often cause you to come to the wrong conclusion. This is why system 2 truly requires slow thinking, patience and an examination of all data.

Can we invest effectively with system 1? Whilst I’m open to arguments to the contrary – financial markets are not sufficiently regular to be predictable. This leads system 1 to be error prone and subject to bias. Hence a long term, analytical approach is more effective and a carefully executed approach to system 2 is best.

For further reading on this I highly recommend Daniel Kahneman’s book ‘Thinking Fast and Slow’ (for a more psychology focused piece) or Malcolm Gladwell’s book ‘Blink’ (for a more economics focused one).