Last Updated on August 10, 2021
Our brains operate on two systems
If you’ve read some of our articles then we hope you’re now convinced about how mental pitfalls can affect your personal finances (If not, check out).
A great way to prevent yourself from committing behavioural biases is to understand how your mind works. Based on research conducted over decades and popularised by Nobel Memorial Prize in Economic Sciences laureate, Daniel Kahneman, who integrated psychology and economic science, our brain has two operating systems – System 1 and System 2.
In Daniel Kahneman’s book “Thinking Fast and Slow”, System 1 refers to fast, instinctive and emotional thinking. System 2 is a slower, more deliberate, and logical thinking. System 1 runs automatically and System 2 is normally in a comfortable low-effort mode.
To understand how your System 1 thinking works, try answering this question:
2 + 2 = ??
It is unlikely that you will require much thinking to answer this question. This is how your System 1 thinking operates. It is turned on for these simple decision-making processes and it operates in a fast and effortless manner.
Now, give this other question a try:
471 x 501 = ??
You’ll probably require more time to solve the second question and are considering reaching for your calculator (unless you’re a math genius). Thinking of how to solve this question switches you to System 2 thinking which is a deeper level of thinking.
System 1 refers to fast, instinctive and emotional thinking. System 2 is a slower, more deliberate, and logical thinking.
The Interaction Between The Two Systems
According to Daniel Kahneman, System 1 runs automatically and System 2 is normally in a comfortable low-effort mode. It is only when System 1 runs into difficulty, that it calls on System 2 to support the analytical process. That is probably what happened to you when you tried to solve the multiplication problem 471 x 501. Simply put, System 2 tends to be activated when a question arises for which System 1 does not have the capabilities to answer.
Activating The Lazy System 2
When it comes to making investment and savings decisions, many of us leave it to System 1 to make the judgment because it’s easier to just follow our emotions or believe something we have heard or read five minutes ago. However, to be a better investor, we should instead engage our System 2 thinking to be more mindful of our decision-making process.
To activate your system 2, try asking yourself the following questions:
Why are you investing or exiting an investment?
One of the dangers of investing is when you subject your investment decisions to your own emotions. Are you investing because the stock has rallied and you are afraid to miss out? Or are you reluctant to sell stocks that are going down, in order to avoid the regret of having made a bad investment? To avoid these situations, always remember why you are investing in the first place. If your hypotheses do not hold anymore, it is probably best to exit the investment or avoid investing. Always remember the nature of the companies you own and the specific rationale for holding the stock.
In what situations could I be wrong?
Ray Dalio, founder of investment firm Bridgewater Associates once mentioned that he finds the smartest people who would disagree with him to try to understand their perspective or to have them stress test his perspective. He attributes this principle to one of key reasons for BridgeWater’s success. Before making any investment decision, it is always beneficial to look at conflicting evidence to make a more well-informed decision. Always ask yourself, “How do I know I’m right?”. By asking yourself that question, System 2 steps in to support your intuition-based System 1 and increases the probability of you being right.
Do the stocks that I am investing in meet the requirements of my checklist?
An investment checklist comes in handy for you to stick to your guidelines and make well thought out decisions. You might have come across a checklist shared by Peter Lynch in his book “One Up on Wall Street”, where he identified the things investors should look out for in stocks. Just to name a few, the price-earning ratio of a company should be in line with their industry peers, and the percentage of institutional ownership should be low. A checklist not only forces you to make meticulous decisions but also serves to remind you of the past mistakes to avoid.
Be Your Own Critic
System 1 is by no means all bad. However in finance, when we are facing uncertainty and our money is at stake, it is worth engaging System 2 to collect more information and make better investment decisions. Remember that when making investment decisions, our first impulse is not necessarily the correct one and it is always best to put our hypotheses to the test.