When I studied economics in university, we were taught that people are rational, fully informed, and always act to optimize their self interest.  This being the case, certain assumptions could be safely made, and thus projections about how the economy would perform.  Over the past almost four decades since I graduated, economists have demonstrated a remarkable ability to get those projections wrong, miss major trends and fail to forecast events such as the 2008 recession.  Daniel Kahneman is not surprised.

Kahneman is the Nobel Prize winning author of Thinking, Fast and Slow, and one of the inventors of behavioral economics.  Kahneman believes that economists have made a fundamental error.  Their idea of the behavior of the average person has little to do with reality.  Real people are not always rational.  They are frequently emotional, fearful, greedy and inattentive.  Few real people are fully informed when they make decisions.  Most often they decide on little evidence using their “fast” thinking capability; they seldom do the hard “slow” work of thinking through a decision.  Finally, real people do not optimize.  They view losses and gains very differently, and act accordingly.  Kahneman says that economics has spent a lot of time thinking about the behavior of a non-existent race of beings he calls “Econs”, when they should have been thinking about the species Kahneman has spent his life studying, “Humans”.

That each of us wages a constant battle between our heads and our hearts is hardly a new insight.  “The heart has reasons that reason cannot know” said Blaise Pascal three hundred and fifty years ago, and although he was talking about religion and not money, the point is the same.  What makes Kahneman different from Pascal is that he has systematically documented the ways in which we let our emotions and fast reactions overwhelm and undermine our powers of thought and analysis.  Reading Kahneman’s book can result in a sense of amazement over how easily we are mislead, and how often mistaken and misguided.  Far from being exempt, the investment arena provides many prime examples.

What are the mistakes that we human investors are prone to make?  Here are some of the ones that we see the most:

  • Selling too soon.  Experiments have convincingly shown that most people will take a sure gain over a probable higher gain.  The desire to lock in winners is very strong and many times, premature sales are the result.  A bird in the hand might be worth two in the bush sometimes, but probably not all the time.  Humans are psychologically addicted to taking the bird in the hand and it takes discipline and practice to override this temptation.  One way investors can combat this is by selling part, but not all, of a winning investment.
  • Riding losses.  Humans hate to lose about twice as strongly as we love to win.  Aversion to realizing losses is very powerful and results in investors holding on to investments they should have sold, and to taking gambles to avoid losses they would never take to make gains.  One of the strongest findings of behavioral economics is the remarkable extent to which loss aversion overwhelms our rational processes.
  • Mistaken reference points.  When a stock has traded at a high price, it sets a reference point in our minds.  We cannot avoid taking it into account when we think of buying or selling.  Even if circumstances have changed radically, we remain anchored to the reference point, making buying at a higher price or selling at a lower price more difficult.  When Nortel fell from $128 to $60, many investors bought more, because they thought of it as a $100+ stock.  Some kept buying all the way down.  They had a faulty reference point.
  • Framing errors.  If patients are told an operation has a 95% success rate, they will agree to it.  If told that it will fail 5% of the time, they won’t.  How the question is framed predicts the answer.  Investors make framing errors such as “Research in Motion is Canada’s best technology company “, leading them to buy it our hold it, whereas framing the issue as “Research in Motion is rapidly losing market share to Apple and Google” causes them to sell the stock.  Framing is an example of our fast thinking overwhelming our slow thinking, and once the fast brain has made a decision, the slow brain will seldom override it.
  • Over-confidence in one’s ability to predict the future.  Surveys repeatedly show that most drivers think that they are “better than average” drivers.  Investors mostly believe that they can predict the direction of stocks and stock markets better than other investors.  Obviously both the drivers and investors are wrong.  On average, their ability is average.  Over-confidence can lead to over commitment to one sector or one stock, to decisions to sell everything due to fear of a meltdown or to go “all in” on stocks to catch a hoped for boom.  The results can be disastrous.

Kahneman makes a convincing case that these behaviours are deeply ingrained and hard to change.  However, by using a systematic approach to investing, working hard to eliminate emotion and put rationality to the fore, the professional investor can act more like an Econ and less like a Human.  Kahneman would say that professional investors are thinking slow.  During the market crash of 2008, many individuals sold in panic, driven by their emotions and by fast thinking.  They sold at the bottom and mostly missed the subsequent recovery.  Professionals, subject to the same feelings but trained and practiced in overriding them, thought slow and held fast, rode out the crisis, and ended up not losing any money.

Slow thinking requires research, analysis and the application of reason.  It is harder than thinking fast.  It results in a more rational approach to decisions of what to buy, when to sell, and how to diversify.  It should avoid framing errors and anchoring to reference points.  Merely by being aware of how easy it is to fall into lazy, fast thinking, the experienced investor can avoid these mistakes.