Although it was published back in 2011, Thinking Fast and Slow is a book referred to often here at LNWM and given to new members of the Investment Team, including me. Written by the Nobel-prize-winning psychologist and economist Dr. Daniel Kahneman, this book shines a light on the faulty reasoning and unconscious biases to which all humans are susceptible, including of course investors, especially during times of greater market volatility like we’re experiencing in 2022. 

Kahneman wastes no time in explaining the difference between “thinking fast” and “thinking slow” by asking questions that seem easy, but whose answers will leave you questioning yourself. In this post, I want to highlight three insights that really stood out for me as I read through Kahneman’s book.

#1. Assume Nothing.

Question: “Steve is very shy and withdrawn, invariably helpful but with very little interest in people or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail. Is Steve more likely to be a librarian or a farmer?”

Librarian is the obvious answer, and most people would stop at that. However, they would fail to consider the ratio of male farmers to male librarians in the US, which is something like 20-to-1. That one piece of information makes it much more likely that Steve is a farmer despite his librarian tendencies. In this instance, the brain draws a conclusion based solely on the information provided (“thinking fast”) but fails to consider outside information that is actually more relevant (“thinking slow”).

Especially during times of high market volatility, many investors make poor decisions by “thinking fast,” giving undue weight to data and facts coming at them – be it headline news or price movement in their portfolios. “Thinking slow” requires us to unemotionally assess what affect new developments have on our ability to meet long-term investment goals and make changes only after rigorous consideration. Read LNWM CIO’s thoughts on this in regard to the Ukraine invasion. 

#2. Put Losses in Context.

Question: “Would you accept a gamble where you would win $1,010 if a coin landed on heads, but lose $900 if it landed on tails?”

Most people would not take this bet, Kahneman’s experiments show, because humans feel losses more intensely than wins — a phenomenon known as loss aversion. The odds are actually in your favor, as this is based on a coin toss: you have an equal chance to win or lose, yet you stand to win more than you would lose. At what point will most people accept this gamble? Only when they can win twice as much as they lose.

One reason people are so loss-averse is that they tend to see potential loss as a one-time occurrence that lasts forever. “If I lose, I’m out $900 that I can never get back.” However, we should remember that in life, gambles are presented to us all the time. In this particular case, if you toss the coin just once, there’s a 50% chance you will lose $900; however, if you toss it 1,000 times, and win just 50% of the time, you will make $55,000. In other words, by seeing each gamble you make as one in a series of many, your ending outcome could be improved dramatically.

In investing, loss-aversion bias is best countered by assessing investment opportunities from a long-term perspective. Just as important is diversifying your portfolio across asset classes, geographies, and vintages (year of investment), which greatly increases the odds of capital appreciation over time.

#3. Invest like a Fox.

Question: What types of people most accurately predict the future?

Many think that successful investing requires being able to accurately predict the future. Kahneman offers evidence to the contrary. He cites a 20-year study in which psychologist Philip Tetlock interviewed 284 professionals who made their living “commenting or offering advice on political and economic trends.” He asked them to predict whether a trend or metric they track closely would be the same, more, or less in the somewhat near future, and then analyzed 80,000 of their predictions. Surprisingly, their predictions were no better than blind guesses. Furthermore, those with the most specialization in a topic often had the most unreliable predictions and made the most excuses when proven wrong.

Kahneman’s explanation: “The person who acquires more knowledge develops an illusion of their skill and becomes unrealistically overconfident.” This type of person Kahneman calls a “hedgehog” per the work of philosopher Isaiah Berlin. Hedgehogs are often expert in one or two areas and tend to make bold, opinionated predictions, while downplaying what they don’t know. The opposite are “foxes” who know that no matter their level of expertise, reality is created through the combination of an untold number of factors, including pure chance; foxes don’t believe they can accurately predict the future. Tetlock found that when it comes to forecasting, foxes tend to outperform hedgehogs, although on an absolute basis their performance was still poor. Foxes’ overall earned a C-, while  hedgehogs’ got an F.

At LNWM we aim to construct portfolios that can withstand the unpredictability of the world, putting our clients in a position to succeed over many market cycles. Along with our new teammates at Wetherby Asset Management, analysts and advisors at LNWM try as much as possible to challenge each other’s assumptions and unconscious biases. We can then help our clients do the same. This incorporation of behavioral finance is core to how we go about creating portfolios that meet the long-term goals and objectives of each of our clients.