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Behavioural economics: Interesting, but what do you do with it?
Behavioural economics has inspired several good books over the past two decades, and people keep buying them. Thinking, Fast and Slow, Blink, Predictably Irrational, Nudge, The Undoing Project, The Power of Habit, Freakonomics and Outliers are all bestsellers. So, the secret is out: research shows that we often stray from the model of homo economicus, which assumes we make rational assessments to maximize utility. The question is, what are we doing with that knowledge?
Our goal is to reconnect you with useful things you might have already read and help connect those ideas to investor behaviour.
Thinking, Fast and Slow by Daniel Kahneman (2011)
System 1 and System 2
The old saying, “You can’t judge a book by its cover,” needs a postscript: “But you will anyway.”
Psychologist and Nobel laureate Daniel Kahneman, author of Thinking, Fast and Slow, spent five decades studying the way we interpret events and make decisions. His conclusion: people can be trained to make more thoughtful decisions but, ultimately, we are biased to making quick, intuitive judgments. Our more reflective processes, in many cases, align to support these judgments.
Through measurements of brain activity, researchers have evidence of fundamentally different processes at work, which Kahneman calls System 1 and System 2. System 1 is uncontrolled, effortless, associative, unconscious and skilled. It comes into play when we respond automatically to a photo of an angry person’s face. Similarly, tasks that have been practiced over and over can become a System 1 response. System 2, by contrast, is controlled, effortful, deductive and slow. It goes to work when people are asked, “What is 17 times 14?”
System 1 responses are powerful. From an evolutionary perspective, this makes sense. Snap judgments help us keep out of harm’s way and they conserve energy. Unfortunately, System 1 responses are also error-prone. This combination, of making errors but being powerful, means we have cognitive biases.
One of the most common patterns is that we substitute an easy question for a hard one. When asked what we think of a politician, we substitute the question “Does he look like a leader?” System 1 comes up with a quick answer: “He’s too young/old!” System 2 would entail time-consuming analysis to provide a more accurate answer: “What are his policies? How do they compare to the other candidate’s?” Since System 2 consumes energy, System 1 substitution takes place, and then System 2’s supporting points are brought in after the fact.
Practical tidbit: Have you ever walked out of a client meeting and thought, “Wow, we didn’t even get to (name the important issue)!” The “halo effect” in meetings is one example of System 1 taking over: issues that are introduced first and most forcefully tend to dominate the entire proceedings. One way to lessen this effect is to have meeting participants write down their ideas before anyone speaks.
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