Thinking, Fast and Slow Book Summary (What I Learnt As An Investor)
6 June 2020
Monish mentioned how he is very good at thinking fast but he noticed that to be a good investor, we need to both be able to think fast and slow well.
I hope this book summary of thinking fast, and slow will allow you to be a happier human being and a better investor. It certainly has helped me to be one.
The book mentioned that we have primarily 2 system, system 1 is the system where we react to things instinctively. System 2 is the more rational and logical system where we think more rationally.
System 1 is thinking fast like for example, our immediate reaction when someone slapped us or if I ask you to calculate 2 + 2.
System 2 is thinking slow like for example, you will need some time to focus and think if I ask you to calculate what is 17 x 24.
System 1 is dangerous because people tend to make the wrong decisions due to the lack of deliberation (which is a function of system 2).
The book gave an example:
A bat and a ball cost $1.10.
The bat costs one dollar more than the ball.
How much does the ball cost?
Do you get 10 cents? If you do, that is wrong and that is the result of System 1.
The answer is 5 cents (If it is 10 cents, the total cost of the 2 items is $1.20 and not $1.10).
The person that gets 5 cents is the person that managed to resist the intuition of system 1 & use his or her system 2 instead. Congrats!
It is primarily not because of a lack of IQ for the people that answered 10 cents. It is just a matter of not trying hard enough or a lack of motivation. A trick that is done by system 1 – it makes your system 2 lazy.
What is intelligence?
How do you know if someone is intelligent? Daniel says that Intelligence is not only the ability to reason; it is also the ability to find relevant material in memory and to deploy attention when needed. I think his definition is amazing. That amazing definition is the reason why I decided to pen down these lessons so I can refer to it in the future. Just like how I list down all my favorite quotes on value investing.
That also means that an intelligent person should remember their mistakes and try to avoid them in the future. To be able to do that, we must find relevant material in memory and deploy attention to that when we need to.
It also says intelligent people avoid avoidable mistakes. That’s why in investment, we need to always be frank with our results and learn from all our mistakes. There is no point in doing well in investing this year due to just luck, we need to work harder to hone our skill so we can be better every year. As they say, the harder we work, the luckier we will get. One way to be a better investor is to avoid avoidable mistakes, for example, only investing in companies that are in our circle of competence and accept that the right patience makes the big money.
Is there a link between intelligence and self-control?
In one of the famous experiments in psychology, there is.
Walter Mischel and his students exposed four-year-old children to a dilemma to choose between a small reward (one Oreo) which they could have at any time or a larger reward (two cookies). They had to wait for 15 minutes in a room with no distractions (no toys, books, pictures, etc).
Long story short, ten, or fifteen years later, the children who managed to wait for a larger reward had a substantially higher score on tests of intelligence, less likely to take drugs, and had better control in cognitive tasks.
In investment, we also need to practice a lot of self-control. Primarily in trying not to be too fearful or too greedy and allow our system 1 to take over.
Patience, patience, and more patience.
Investing genius consists of one part patience and one part compound interest (Philip Carret).
If one tends to say the first thing that comes to their mind, that person has a weak system 2 and a strong system 1.
For example, if we see the stock of a company we like fall by a lot, our system 1 may say that this is a good opportunity. But system 2 – which is the slow thinking – should say, why did it fall by a lot? Is the problem temporary or permanent? What is our probability of being wrong and being right? What makes us so sure? I think system 2 – thinking slow – is more important than system 1 in making investment decisions.
But system 1 is also important. Why is system 1 important? Because it may give us clues based on our past experiences, subconsciously, on whether the situation is an opportunity or not. It can allow us to act fast and accurately.
For example, in the most recent COVID-19 short stock market crash, it did not take me long to decide (and am currently still vested as of 6 June 2020) to have about 27% of my portfolio in Carnival Corp at an average price of about $14. It was 50% system 1 at play and 50% of system 2.
In short, system 1 does help but it has to be combined with system 2 because system 2 is more rational.
We need to remember that associative activation happens in system 1. It is when a complex constellation of responses occurred quickly, automatically, and effortlessly. What happens is, for example, I give you two words: banana, vomit. You might automatically link the two words and think that the banana causes the vomit.
Our system 1 treats the two words (banana and vomit) as reality. The emotional and physical response is real. We think with our body, not only with our brain.
The above links to the idea of priming. Which is the influencing of an action by an idea – also known as the ideomotor effect. This means that by being exposed to a word, a sentence, or headlines of the news, our body can be affected by it immediately. Which is also a function of system 1.
I think the effect of priming by reading good news headlines about stocks we hold might be also why we tend to not want to sell our winning stocks because we are feeling good. And we tend to want to sell our stocks when there is bad news about it – because we are feeling bad.
We need to be aware of the effect that priming does to us in order for us to think more rationally and make better decisions.
Daniel says in the book that system 1 provides impressions that often turn into your beliefs, and it is the source of the impulses that often become our choices and our actions.
Yes, system 1 can be a potential source of our rapid and often precise intuitive judgments, but it can also be the source of many systematic errors in our intuitions.
Often times our system 1 can construct a story and fool our system 2 into believing it
The effect of priming is truly real. Have you noticed that when you smile, you actually feel better?
I titled one of my VIM weekly take as “Cool Heads Think Better.”
I noticed how I feel affects how I think. How I think also affects how I feel. My natural conclusion for that is that when I feel bad or uncomfortable, I will not make any investment decision. Only when we are feeling good, calm, and rational, then I should make decisions.
What Daniel says in the book is that when we are in a state of cognitive ease caused by repeated experience, good mood, etc, we also tend to immediately believe what we hear, trust our intuitions and feel familiar with the current situations. When we feel strained, we are likely to be more suspicious, vigilant, and invest more effort in what we are doing, we will feel less comfortable, make fewer errors but we will be less intuitive and creative than usual.
I think that means that we should make decisions when we are feeling comfortable but be wary of system 1 – which is trusting our intuitions too much and believing in what we hear too fast.
Why not make decisions when we are feeling unhappy or uncomfortable? Because we will lose touch with our intuition.
Also, when we are in a very good mood, it is also worth noting that we should be careful because our system 2 could be weaker than usual.
One of the effects of priming is also the illusion of familiarity. For example, if we have done plenty of research on that particular stock, we will feel more familiar with that stock and tend to want to do something about it. But the danger is that it might not be a good opportunity and yet because we have the illusion of familiarity, we may want to do something for the sake of doing something. Which is in my opinion, dangerous.
There is also the illusions of truth. The illusion of truth is also created by the impression of familiarity caused by system 1, and system 2 relies on that for true or false judgment. When something is repeated often enough, people tend to believe it – even if it is false.
For example, is value investing buying and holding companies for many years, if possible never to sell them like Warren Buffett? Not necessarily. If you are holding a bad company that will likely to continue doing badly and worse over time because of a lack of competitive advantage, why still hold it.
The reason is that familiarity (and system 1) is not easily distinguished from truth
We should be wary of accepting something familiar as the truth that is automatically inferred by system 1.
System 1 also automatically searches for causality in a lot of situations. A story in Nassim Taleb’s The Black Swan illustrates this automatic search of causality when Saddam Husein was captured and in the morning bond prices rose and Bloomberg News Service flashed the headline U.S. Treasuries rise: Hussein capture may not curb terrorism. Half an hour later when bond prices fell, the revised headline read U.S. Treasuries fall: Hussein capture boosts allure of risky assets. That event was designed to explain what happens in the market that day, but a statement that can explain two outcomes of the opposite end explains nothing at all.
System 1 likes to jump into conclusions. It is alright to jump into conclusions if the conclusions are likely to be correct and the cost of an occasional mistake is manageable – plus if it saves time and effort. But system 1 is risky in an unfamiliar situation where stakes are high and there is no time to collect more information. In this case, system 2 needs to deliberately intervene.
System 1 is dangerous because when it jump into conclusions, only 1 interpretation came to mind and we did not think of the ambiguity nor do we keep track of the alternatives that it rejects, or even the fact that there are any alternatives.
It is system 2 jobs to doubt something, system 1 is very gullible by nature.
Confirmatory bias is also a symptom of system 1. People tend to seek data that are likely to be compatible with the beliefs they currently hold.
System 1 favors uncritical acceptance of suggestions and exaggeration of the likelihood of extreme and improbably events.
The Halo effect is the exaggerated emotional coherence bias a person can have. It is the tendency to like (or dislike) everything about a person or things. It is one of the ways system 1 represents the world, which is simpler and more coherent than the real thing. Have you noticed that you tend to be biased and like a particular stock that you own more than it is warranted? You might have not noticed it, because of the halo effect. Because you like the stocks that you own, it is less likely that you will be objective in seeing the bad side of it.
The combination of a coherence-seeking system 1 with a lazy system 2 implies that system 2 will endorse many intuitive beliefs – which can be wrong.
Even when we deliberately seek pieces of information using system 2, system 1’s input never ceases.
This is a problem because one of the main functions of system 2 is actually to monitor and control suggestions from system 1. But sometimes, when we are tired, system 2 is lazy. Because we are naturally drawn to solutions that use up as little mental energy as possible.
So basically, system 1 likes to jump into conclusions based on the limited data that is available. It likes to jump the gun! It does not really care about the quantity and quality of the informations given. Hence, we have impressions and intitions based on system 1.
What is a potential solution then for system 1 that likes to jump the gun? I think we should ask more of questions like, “What would I need to know more before I formed an opinion or conclusion about xxx?”
Thinking fast, and slow on our naturally occurring bias caused by system 1 and the lazy system 2
The law of small numbers is a bias in which we believe that what is happening within a small sample is representative of the population from where that sample is drawn. This is a bias again done by system 1 that goes against the law of probabilities. We should always ask, what is the probability of that thing happening.
Anchoring effect happens when a particular value for an unknown quantity influences our estimate of that quantity. For example, it does not matter in relation to the intrinsic value of a particular stock no matter at what price we bought it at. But people tend to anchor when to sell that stock based on the price that they bought it at.
The higher the level of confidence, the higher the cost of a mistake. The book talks about taming intuitive predictions – which is caused by system 1 who is being overconfident. For example, if our intuitive prediction is very favorable, we should take into account the strength of our evidence and regress the prediction towards the mean/average.
We should always think in terms of probabilities.
Thinking fast, and slow also talked about the bias we have when faced with choices
In prospect theory, it says that we are likely to seek out risk when we are faced with bad choices.
While in a normal situation, we are risk-averse. I see this happen all the time.
In the book, Daniel gave the example below:
Problem 1: Get $900 for sure OR 90% chance to get $1,000?
Problem 2: Lose $900 for sure OR 90% chance to lose $1,000?
Most people will choose to get $900 for sure for problem 1 because, in that kind of normal situation, they are risk-averse and do not want to take the 10% chance to lose $1,000.
Most people will choose for the 90% chance to lose $1,000 for problem 2 because they want to take the gamble to win $1,000 using that 10% chance. Even though if they decide to lose $900 for sure, he or she will keep the $100 for sure.
In stock investing, in value investing, the second problem happens when an investor refuses to realize their loss in a stock even though they know that the intrinsic value of that particular stock is really bad and there is a chance they will lose everything. That’s the prospect theory in action.
The endowment effect says that we naturally give more value to certain things simply because it is ours. Have you noticed that you tend to resists selling the stocks you own at a loss? That is the endowment effect and loss aversion effect at play.
The rare events bias is that people often overestimate the probabilities of events that are very unlikely. And they take this bias into account in their decision-making process. To solve this, we should not focus too much on one scenario because it will allow us to overestimate its probability. We should set up specific alternatives so they all add up to 100%.
Reversals bias happens when we focus too much on one particular lens for evaluation. When we see cases isolation, we are likely to be guided by an emotional reaction of system 1. We should broaden the frame and use a more careful assessment, so we get a more reasonable decision. That’s why when analyzing a stock, we need to look at many aspects of the company and reach a balanced understanding and conclusion for our bet.
To solve reversals bias, use checklist.
Framing allows us to shift our perspective of reality. For example, if we lose money on an investment, one can easily feel better by framing the outcome in terms of how much money they kept rather than how much they lost. Framing is very powerful and it is used in many ways and it works because most people have a lazy system 2 and think primarily by system 1.
Thinking fast, and slow ended very well in sharing some philosophical life lessons
We have an experiencing self and a remembering self. Our remembering self keeps score and governs what we learn so we can make decisions in the future.
It is the comparing of experience and memory.
For example, a person who is thinking that their failed marriage which ended badly entirely from the perspective of remembering self may think it is bad. But a divorce could be like a symphony with a screeching sound in the end, it may end badly yes, but it does not mean it was all bad.
Life as a story bias says that most people do not care about their experiencing self, they normally care more about the memories collected.
For example, have you noticed that a lot of people devote the entire vacation to construct memories? When they should put away the camera and enjoy the moment instead?
I think one of the greatest bias in our life is the focusing illusion where people pay attention to selected moments and neglect what happens at other times. The mind is good in making stories but it cannot really process time well.
For example, people thought that a large house will make them happier in the long term, but it could be a symptom of focus illusion.
Nothing in life is as important as you think it is when you are thinking about it summarizes focusing illusion the best.
Linking to focusing illusion, one Buddhist philosophy also says that there is nothing permanent in this world. So is, whatever it is we are focusing on right now.
Whatever that we are experiencing or focusing now. Be it sadness, loneliness, negative, or positive emotion. We should just accept it and let it pass – think rationally using our system 2 – instead of succumbing to system 1 (which includes plenty of focusing illusion).
Biggest takeaway? The next time you want to buy that big shiny new house, that new car, that new watch, that promotion, that nice meal that could ruin your diet, or if you beat yourself up over a loss or a missed gain in investment, ask yourself: is system 1, focusing illusion at play? Is it really that important?
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