- Fast and Slow
June 5, 2012
When advisors want to understand why their clients make seemingly irrational financial choices, odds are they will find answers in the research of Nobel-winning behavioral economist Daniel Kahneman. But guiding clients toward a better financial future is only one way to apply behavioral finance. Kahneman says we solve virtually all problems, not just financial ones, with two distinct types of thinking.
His recent book, Thinking, Fast and Slow, was a 2011 bestseller. It summarizes his lifetime of work on how the mind works, covering many topics familiar to those who follow behavioral economics and finance: prospect theory, overconfidence, loss aversion, anchoring, separate mental accounting, the representativeness bias and the availability bias.
Kahneman, who, at 78, is still teaching at Princeton, recently discussed these and other discoveries at the 2012 CFA Institute Annual Conference, which took place in Chicago on May 6-9.
I’ll look at how Kahneman’s research can be applied in the context of investing, but first let’s examine the central subject of his book: our two ways of thinking.
Think fast! Or think slowly?
Try this experiment: Just before making a left turn in a busy intersection, begin to multiply 17 by 24. I’m kidding; please don’t. You’ll either quickly abandon the arithmetic problem or wreck your car. But I’ll bet you can add two plus two while making a left turn without any problem whatsoever.
What is the difference between the two tasks?
Most people would say that one of the tasks is easy and the other is hard. But Kahneman, who won the 2002 Nobel Prize in economics for work relating economic decision-making to psychology, says that there’s more to it – a substantive difference, not merely one of degree.
Adding two and two is done using what Kahneman calls System 1 thinking, the kind of fast thinking that feels like it is done on autopilot. The product of 17 and 24 is arrived at using System 2 thinking – slow, deliberate thinking that involves an entirely different physiological process, one that (for example) interferes with driving a car.
When you engage in intense System 2 thinking, Kahneman says, something happens to your body. Your pupils dilate. Your heart rate increases. Your blood glucose level drops. You become irritable if someone or something interrupts your focus. You become partially deaf and partially blind to stimuli that ordinarily command your attention. Kahneman writes that “intense focusing on a task can make people effectively blind.”
My grown son recently reported an occurrence of a related phenomenon, blindness caused by having made up one’s mind. While he was preparing to perform in a concert, his girlfriend paid him a surprise visit, hundreds of miles from either his home or hers. Despite increasing efforts to recognize the strangely familiar person approaching him from a distance, he couldn’t figure out who she was until she was quite close. There is nothing wrong with my son’s eyesight. Having decided, using System 1 thinking, that his girlfriend was far away, it was physically impossible for him to see her until she was right under his nose. He was unable to invoke System 2 thinking to figure out that maybe she had taken an unplanned trip. He was temporarily blinded by an idea.
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