Daniel Kahneman is a Nobel Prize awarded psychologist,
who's most famous for his work on the psychology of judgment and decision-making. In 2011,
he released the book "Thinking Fast and Slow" on these subjects.
Thinking Fast and Slow presents the concepts of how the human mind perceives and analyzes its surroundings by introducing two systems:
System 1, which is the fast thinking and system 2, which is the slow thinking.
This book is not about investing, but Kahneman's concepts have great implications in any investors decision-making process. Therefore, for each takeaway,
I will present the concept in general at first, and after that, I will talk about implications for you guys as
investors. Now, to get the most out of this video I suggested to grab a pen and a paper.
To truly appreciate the work of Kahneman,
you must see for yourself how you act in certain situations. Pause a video and do that now, please.
You ready? Let's do this!
Takeaway number 1: Fast and slow thinking - system one and two introduced. For this video subjects are asked to count
how many times the girls wearing white shirts have passed the ball.
People can usually tell the correct number, which is 16.
However, they failed to notice the gorilla who walks across the floor in the middle of the cut.
50% of people fail to notice this! I know that I did the first time I washed it!
How is it possible to miss out on something
so obvious? The answer lies within the two different systems that humans use to perceive and act in our environment.
The first system. Let's call it system 1, operates automatically, quickly, and with very little effort.
System 1 is the "fast thinking" that Kahneman refers to in the title of his book.
The second system,
let's call it system 2 for simplicity, allocates attention to mental activities that requires effort when certain stimuli activates it.
System 2 is the sloooooow
thinking, refer to in the title of the book. Both systems have been necessary for the survival of the human species.
Problems occur when system 1 is
influencing a system 2 decision in an unfavorable way, or where system 2 is left out of that decision-making process altogether.
System 2 can be seen as a very lazy person.
He's a great diagnostician, but tries to save his energy whenever possible and it's often influenced by the more outgoing and active system 1.
In the case of the gorilla,
system 2 had its full attention on counting how many times the ball was passed and therefore failed to notice the gorilla.
Implications for the investor: Well, there are many of them as we shall see in the following takeaways.
One that is related to the laziness of system 2 is that if you start with automatic monthly transfers,
you are more likely to achieve your financial goals.
To cancel a monthly deposit is an activity for system 2, since you're interrupting a pattern.
On the other hand, if you don't use automatic monthly transfers, every single deposit you make will have to activate system 2.
Use the laziness of system 2 to your advantage, instead of your disadvantage.
Just sit back, relax and enjoy this video.
You don't need a lot of brains in this business.
I mean, I've always said if you got an IQ of 160,
give away 30 points to somebody else because you don't need it in investments. What you do need is emotional stability.
50 on the way up! 80 down! 50 up, 80 down!
But plenty of people will try and trade a volatile market like this with incredibly tight stops.
Let's move on to something completely unrelated:
Which word hides behind this word fragment?
What about this one? Did you come up with:
Investor & fit?
Inventor &
fat would also match but you are not as likely to pick these. The reason why you're inclined to choose
investor and fit is called the priming effect, and that's our second takeaway.
Moments before I showed you the fragmented words, you watched a couple of cuts that were related to the subjects of fitness and investing.
Although the words investor and fit weren't stated explicitly - they prime the idea of them.
A wonderful example that Kahneman brings up in the book is one where young students have been primed with words associated of being old.
They are then asked to walk from the current room to another one down the corridor where the next assignment is waiting for them.
The students who were primed moved slower,
imitating an old person, than the control group who weren't primed with the idea of being old. Now, that's powerful!
Implications for the investor:
Priming has huge consequences for investors. Running for the exit door during market crashes is one of them.
Although priming isn't the only psychological bias in effect during a bear market,
it's certainly one of them! The financial news that are telling us to GET OUT are very hard to ignore.
System 1 can't recognize where data comes from, nor the quality of the data. With this in mind, consider another example:
A friend at work recommends a stock. You later read on a forum about the same positive view.
After that,
you find an analysis from one of the famous financial newsletters that was published a week ago with the same positive opinion.
Although it's highly likely that both your coworker and the person on the forum have based their opinions on the recently published
professional analysis, you treat the data as three different sources, confirming the same thing - that the stock is a sound investment.
You can't avoid being primed, but you can reduce the effect that it has.
My recommendation is that you must commit to being consistent to an investment process. For instance,
you put X% of your monthly salary into a brokerage account. No matter if the market has gone up or down.
You buy or sell a company when it fulfills a couple of predefined criteria,
no matter if your best friend is advising you to or not.
Please answer the following two questions (without support from Google!) Are there more or less than 16 Americans for every Swede?
How many Americans are there for every Swede?
Now, on to the next set of questions. Can you fit more or less than 44 Swedens into one USA? (By area I mean)
How many Sweden's can you fit into one USA?
For the first set of questions, there are more than 16 Americans for every Swede.
Approximately, there are 32 Americans for every Swede.
320 million versus 10 million. For the second set of questions. You can't fit that many Swedens into one USA.
Approximately, you can fit 22 Swedens into one USA. Now comes the interesting part:
Was your answer higher or lower than the actual number for the first set of questions?
My guess is that it was lower.
What about the second set of questions, higher or lower? If you're like most people, it should be higher.
The secret to this trick is called "the anchoring effect",
and this is our third takeaway.
When faced with an estimation that you don't know the solution to, you use whatever other values that you suspect can be connected to
the solution. In this case the 16 from the first problem and the 44 from the second act as anchors.
System one will prime you towards these numbers, although they might not be relevant for the problem at all!
Anchoring is used frequently by retailers. When you see a price tag with: Before - $300, Now - only
$150! It's difficult to not think of it as a bargain.
Implications for the investor: Anchoring is a bias that is affecting us when we try to make rational investment decisions as well.
Consider this stock price chart: Would you say that this company is cheap?
Most people know that you can't answer that question by simply regarding the price chart of a stock.
But we are somewhat tempted to answer: "Yes! It's cheap! It's almost three times as cheap as in the beginning of 2017!"
This is all due to the anchoring effect, and although people don't want to admit it,
this is one of the reasons as to why private investors are overrepresented in buying previous losers in the market.
NEVER pick stocks based on those premises.
Please take a moment to answer this question:
You have been exposed to a disease, which causes certain (but painless) death in 7 days. The risk of you catching
it is one in 1,000.
How much would you be willing to pay for a vaccine that will cure you? You have no way to know if you are
contaminated or not.
Now, consider another question:
Volunteers are needed for research on a new drug, but there's a risk that you catch a deadly disease.
This happens in 1/1000 trials.
The disease is painless, but you will certainly die in seven days if you catch it.
How much would you demand to be paid to participate?
Most people demand a much higher payment in this second example than they are willing to pay to cure themselves in the first.
Reportedly, subjects tend to demand 50x more for the second than the first although from a mathematical standpoint,
they are identical! They are both answers to the question:
"How is a 1/1000 probability of dying in seven days priced?"
The reason why people tend to price the first example lower is due to the framing effect,
and this is our fourth takeaway. The framing effect states that different ways of presenting the same information,
evokes different emotional responses.
Consider the two examples again.
It feels much worse to be on the losing side of example 2, as you in that case took an active decision.
Just neglecting to act as in example 1, is much more emotionally acceptable. Basically, you can just blame bad luck!
Implications for the investor:
I consider annual reports to be one of the greatest assets when I evaluate if an investment is worthy of my money or not.
They are, however, subject to a lot of framing bias.
Although the company rarely will straight-up lie to you, they're often free to choose how they present certain statistics.
Consider this announcement which could have been a statement from a shareholder's letter:
"Our company is breaking new records this year! Our revenues up 12% compared to last year!"
When you see something like this, you must insist on digging deeper. This might be great and all, but what about earnings? Oh
"Well ... we had a temporary increase in procurement costs ... and experienced increased competition ... So our marketing costs also increased ..."
"Earnings are down by 20% :( "
Another company might state something along these lines:
"Our company's breaking new records. This year revenues are up 12% and profits are up 50%!"
"Also, this is the best growth on a year-to-year basis ever experienced!"
Once again, this is probably not the whole story. How is the market doing?
"Uh, well ..."
"Competitors are actually growing faster than we are, at a pace of 20% yearly. So we have lost market shares this year ...."
"Just just like we did last year ..."
Moral of the story: A number or statement without its proper context can sound persuasive, but it's all due to the framing effect.
Know this and you might be able to avoid becoming a victim of it!
Matthews International is a publicly traded company selling coffins for funerals. Do you want to invest in it?
If you answered "yes" to this question you:
A) Have had Matthews International on your investment radar for a while, or B) are a madman who loves death and despair.
If you answered "maybe"
congratulations! You passed the test, so to speak. A few of you probably answered
"no", falling for the fast thinking of system 1.
This bias is called "cognitive ease" or "substitution", and it's the final takeaway of this video.
It states that, when faced with a difficult question, where a simple solution is not available, intuition still has the chance.
It will have an answer ready for you. Although it's not an answer to the original question! The question you faced -
"Should I invest in Matthews International?" was difficult, but the answer to an easier and related question -
"Do I like funerals/coffins?" came readily to your mind, and determined your choice.
Obviously, an investment decision can never be made with such limited amounts of information.
Sure, the funeral industry might not be as hot as machine learning or a drone technology are right now.
But if Matthews international has great management,
solid finances,
competitive advantages, a strong distribution network for geographical expansion, and is priced at
P/E 5, you'd be a fool to decide that you're not going to invest in it just because you don't find the industry sexy enough!
You cannot trust your gut when it comes to investment decisions.
The reason is because your gut has substituted the original complex question for a simpler related one.
Implications for the investor:
I found this book to be very interesting, and the applications for investors are clear in many cases.
Therefore, there will be a second part of this video,
which I've either
already produced - in which case I will link to it in the upper right corner now - or I will release it in a few days.
Stay tuned!
Meanwhile, don't forget to watch my latest video. If you've already watched it - great, then here's another suggestion.
Also, if you enjoyed this content, don't forget to subscribe to The Swedish Investor channel for more weekly videos.
Cheers guys!