The Limitations of Thinking Fast
The world of economics was forever changed in 2002 when the Nobel Prize went to Daniel Kahneman[i]. Kahneman notably is not an economist, but a psychologist. Economic theory had relied heavily on the assumption of “homo economicus” (that man was rational and utility maximizing, uninfluenced by bias) this turned out to be something that existed in theory but was absent from reality.
“Prospect Theory: An Analysis of Decision Under Risk[ii]” the 1979 paper by Daniel Kahneman and Amos Tversky[iii] essentially created the modern field of behavioral economics[iv]. Their work showed that we are predictably irrational when it comes to certain economic choices and that we were all victims of cognitive biases that could lead us astray especially when it comes to uncertainty and the chance of loss.[v]
On an evolutionary timescale, money just appeared out of nowhere and our instincts have not had time to catch up. There was no survival advantage to being able to think exponentially or understand statistics. The idea of planning for the future is way too recent for our intuitions informed by millennia of danger and scarcity to consider.
Daniel Kahneman’s 2011 book “Thinking, Fast and Slow[vi]” explores our two modes of thought, the automatic and effortless “System 1”, and the calculated and effortful “System 2.” More importantly, it shows there are predictable ways our “System 1” can be tricked and that being aware of the traps does not make us immune to them. Even experts are prone to the same errors.
We are constantly bombarded with information overload. Our brains evolved for this though, so we’re actually really good at filtering information and making quick and automatic decisions a lot of the time. We are also pretty good at prioritizing when we need more effortful thinking; however, when it comes to financial decisions our intuition is naturally terrible because evolution doesn’t care about what happens after you pass on your genes.
However, as Kahneman states, “…it is easier to recognize other people’s mistakes than our own.” The good and bad news is that the types of cognitive biases and errors we are prone to make are universal, but hard to recognize in ourselves.
Our brains evolved over millions of years for survival, that’s what “System 1” is designed for. “The nervous system consumes more glucose than most other parts of the body, and effortful mental activity appears to be especially expensive in the currency of glucose.” Mental shortcuts were essential for our ancestors and are still incredibly useful today but far from perfect.
So, how can we avoid these mistakes and overcome “System 1” when it actually matters?
Collaborate, the Nobel Prize winning research showed that knowing about these errors doesn’t make us less susceptible but that we can more easily see them in others! There are plenty of ways to accomplish this, to have someone able to help you avoid the pitfalls. Your spouse, if you have one, might already have a habit of pointing out your mistakes. So, one possibility would be for you both to learn all about the various cognitive errors and biases so you can blindly continue to make the mistakes yourselves while pointing out the mistakes of your spouse!
However, we want to help you sleep better at night, and hopefully in the same room, so there is another way.
One of the biggest values we can provide as advisors is mistake avoidance. It isn’t sexy, unless you compare it to being banished to the couch, but it can be the difference between staying on course or derailing. For years, Michael and I have been students of behavioral finance and continue to try to learn everything we can about the types of scenarios that are most likely to make it easy to make an automatic but counterproductive decision about your financial future.
The unfortunate truth is that mistakes can very quickly undo even decades of doing the right thing but that is why someone who can help you avoid them can be so incredibly valuable.
[iii] Sadly, Amos Tversky died at the age of 59 in 1996, the Nobel Prize is not awarded posthumously, if it were he would have shared the 2002 prize with Kahneman https://www.newyorker.com/books/page-turner/the-two-friends-who-changed-how-we-think-about-how-we-think