Posted on April 17, 2013 by David Laidlaw

Daniel Kahneman wrote a fascinating book which was published in late 2011 titled Thinking, Fast and Slow. Kahneman describes two systems of thought: System 1 and System 2 that operate within the human mind. System 1 dominates our every waking moment searching out patterns and applying snap judgments. System 1 is intuitive, but not rational. System 2 is the rational thought process that is slow and requires self-control. Utilizing System 2 takes effort to employ and burns metabolic resources at a faster rate in the process.

Kahneman’s thesis is that the biases inherent in System 1 interfere with the rational process of System 2 and lead to faulty decision-making. This interference can be seen in many different investment contexts.  For example, whenever a particular market (stock, bond or commodity) moves in a certain direction, the financial media and investors are always searching for an explanation for that movement. Radio snippets or brief news items on the Internet often offer rationales such as the market rose today because unemployment claims declined. The price of a diversified index such as the S&P 500 is determined by over 100 million trades in a given day and it defies logic that one factor could explain the reason for that market movement.

Another example of this phenomenon is “priming.” Priming occurs when somebody is used to a certain status or presented with information that anchors an expectation. Kahneman uses an example of an experiment in which he asks one group of test subjects whether or not the tallest redwood tree is more or less than 1,200 feet tall. He then asks that same group what their best guess is concerning the height of the tallest redwood. With another group, he asks the same questions, but substitutes 180 feet for 1,200 feet. The first subjects’ average response was 844 feet compared to the second group’s estimate of 282 feet. (The tallest redwood trees are about 370 feet).

Many investors are primed by past experiences of much higher interest rates than exist today. For example, many investors assume that a portfolio of fixed-income securities can safely provide a yield of 5%. However, this is roughly 2–2.5 times the rate of return that can be obtained by a high quality short-duration bond portfolio. 

Another area where System 1 intuitive thinking impacts rational assessment involves the intersection of politics and investment performance. During 2012, the country experienced a divisive election that produced a government that is evenly split between the Democrats and Republicans. These political divisions spilled over into the fiscal negotiations that were just concluded. For many, this backdrop caused System 1 to view the market through a chaotic political lens. Therefore, a number of investors concluded that 2012 was a volatile year with poor investment returns. However, in actuality, 2012 was a superb year for almost all asset classes. Domestic Stocks appreciated by 16% (S&P 500); bonds appreciated by 3.8% (Barclays Aggregate); and home prices advanced 4.3% from October 2011 to October 2012 (Case Shiller’s last data point).