Thinking fast and slow

Introduction

Understanding the thinking process behind the human behavior can help an individual gain an edge in such things as negotiating, deciphering market psychology and thinking probabilistically all of which important to the finance professionals. Behavioral finance starts with the central premise that individuals do not always act rationally as frequently described in the mainstream economic theory.

 The representative agent is always portrayed in a normative way by the standard approach by stating how individuals ought to act given a rationality hypothesis. Thus, economic theory has long made use of this agent to analyze various economic phenomena such as portfolio allocation, the price formation in financial markets through the axioms of the theory of choice under uncertainty.  Various theories struggle to capture the real-world data, leading to some “puzzles” in economics. Researchers have in that case made efforts to rationalize such behavior of the representative agent both on the empirical and theoretical ground. The behavioral economics thus presents a collection of diverse approaches to solve the problems in finance. In doing so, researchers draw on many disciplines, among which psychology occupies a very special place. In thinking fast and slow, Kahneman seeks to focus on why people fail to make rational decisions and how economic models can be used to predict human behavior. The book discusses the various heuristics that are a part of the automatic thinking process of humans which can adversely impact investor decisions. The author explores multiple topics in behavioral economics including the substitution heuristic, prospect theory, and the framing effect. This paper presents a reflection of the book Think fast and slow and the illustration of the application of concepts in different aspects of finance.

Two systems

According to the Kehneman, human brains are comprised of two characters, one that thinks fast, and one that thinks slowly. The first character; System 1 operates automatically, involuntary, intuitively and effortlessly like when we read an angry facial expression, drive or recall our age.  The second character System 2 requires, reasoning slowing down, solving problems, deliberating, computing, concentrating, focusing, considering other data, and not jumping to conclusions like when we choose where to invest money, calculate a math problem or fill out a complicated form. Thus, System 1 operates on heuristics that may not be accurate while System 2 requires effort evaluating the heuristics and is prone to error. However, these two systems often conflict with each other. The book offers insights on how to recognize situations in which mistakes are likely to occur and how to avoid significant mistakes when stakes are high.

Many investors probably make mistakes, not realizing errors until it is too late, as relatively few of us financial professionals or unbiased thinkers. We may have to ask then ourselves, “What was I thinking?” While the Behavioral Finance series outline the mental shortcuts that decision makers rely upon to make a decision, there is a need to consider how we think in addition to what we think. Dr. Kahneman introduces the concept of decision-making “agents” using a two-system model of the brain that functions based on automatic and controlled processes.

While System 1 is responsible for impressions, intuitions, feelings and other thinking fast processes, System 2 handles impulses sent by System 1 and converts them into beliefs and impulses into actions thus a slow thinking functionality. The automatic operation of System 1 is what prompts us to make decisions or at times errors based upon rules-of-thumb. While System 2 processes the impulses provided by System 1, the biases generated may not always be detected given that System 2 may not be aware of the error. Thus, the only way to detect such biases may be through the conscious use of System 2. Essentially, using system 2 as the more controlled thinking system can help avoid mistakes. Kahneman’s two-system model suggests that System 2 can be applied to provide more deliberate thinking. Attention and effort: Thinking slow has an effect on our bodies, such as having limited observation when attention.  Since thinking slow requires effort, we are prone to think fast.  As humans, we think fast to accomplish routine tasks while we think slow in order to manage complicated tasks.

The lazy controller: Some activities can drain our energy just as calculating while walking. That’s  is why being interrupted while concentrating can be  frustrating and explains why multitasking while driving is dangerous, why we forget to eat when focused on an interesting project and why resisting temptation to make an extra effort when we are stressed.  Self-control decreases when we’re mentally exhausted or hungry. Due to this reality, we are prone to let System 1 take over impulsively and intuitively. Thus, many people do not make considerable effort to think through the problem. Accordingly, intelligence is also the ability to find relevant material in memory and deploy attention when needed.  The failure to access memory makes us prone to make mistakes in judgment.

The associative machine: The conscious and subconscious allows the allow individuals to think about an associated idea. Things outside the conscious awareness can influence how individuals think. Such subtle influences also affect behavior. However, we cannot we can behave our way into feelings since we are not rational thinkers.  We, therefore, have the potential for errors as various things influence our attitude, judgment and behavior that we do not recognize. Cognitive ease: Things that are more familiar, easier to compute and easier to read seem truer than things that require hard thought. If a judgment is based on strain or impression of cognitive ease, Predictable illusions inevitably occur.  But how do you know that a statement is true?

Jumping into conclusions: There is a tendency among human beings to search and find confirming evidences instead of counter examples.  Conclusions are efficient to move closely to a correct answer and often the jump saves much time and effort. However, jumping to conclusions is risky especially when a situation is unfamiliar, the stakes are high and there is less time to collect more information.  System 1 is responsible for filling in ambiguity with automatic guesses and interpretations and rarely considers other interpretations. While System 1 makes a mistake, System 2 jumps may consider alternative explanations. Thus, we are prone to over-estimate the probability of unlikely events and accept uncritically every suggestion when we rely on system 1. The Halo effect also plays a role in making decisions. A good first impression tends to color positively future negative impressions.

The problem is that our intuitive judgments are impulsive and does not critically examine our thoughts clearly. It is critical to remind System 1 to stay objective and resist jumping to conclusions and hence enlist the evaluative skills of System 2. As finance professionals, we need to stay focused on hard data before us and not lean on information based on impressions or intuitions. We should combat overconfidence by basing our beliefs on critical thinking as opposed to subjective feelings.

Judgment: While System 1 relies on its intuition, it is prone to ignore sum-like variables.  Individuals often rely on often unreliable intuitive averages while failing to calculate accurately sums.  Thus, we are prone to evaluate a decision without evaluating which variables are most important; the “mental shotgun” approach.  Substitution: When confronted with a perplexing problem, we are likely to answer the simpler question. We, therefore, rely on an estimate of another less complex outcome Instead of estimating the probability of a certain complex outcome.  We are prone to replacing vexing problems with easier problems thus the Potential for error.

Heuristics and biases

Human brains have a difficult time with statistics. We tend to lend the outcomes of small samples more credence than statistics warrants even though small samples are more prone to extreme outcomes than large samples. Even if but System 1 is impressed with the outcome of small samples, it shouldn’t be. Given that small samples are not representative of large samples, larger samples are more precise. Human err when we intuit rather than compute because we make decisions on insufficient data.

System 1 constructs coherent stories from mere scraps of data suppresses ambiguity and doubt. System 2 weighs those stories, doubts them, and suspends judgment. Although, disbelief requires lots of work System 2 is required to do its job and allow us to slide into certainty.  There are many facts that lead us to making connections where none exists. This is connected to the how the associative system generates feelings of confidence.  The combination of different factors confidence in the presence of data to the contrary leads to overconfidence. According to Kahneman, traders agitate because they tell themselves coherent stories. However, even Fortune 500 CFOs tell themselves stories that are coherent and not justified by facts. In fact, CFOs at Fortune 500 firms may be overconfident than CFOs of smaller firms.

The author also discusses the subconscious phenomenon that makes individuals settle on making incorrect estimates as a result of previously heard quantities. People feel 35 mph is fast when they have been driving ten mph but slow if they have been driving 65 mph. Also, buying a house for $200k seems high in the case the price was raised from $180k but low if in the case the price was lowered from $220k.

What Can Be Done With Behavioral Finance?

There are several things individuals can do with the knowledge gained from behavioral finance.  According to Kahneman, there are situations in which individuals are more likely to make a mistake.  One example is in the case of numbers such as in a negotiation. In such as a situation,  a form of priming regarded anchoring happens where the number mentioned tends to become plausible because it was mentioned. The author suggests that if the other side comes up with a number in a negotiation brings up a number that the party considers your range, you can make a big loud dramatic scene in order to disrupt the priming effects of System 1 in a deal. In the case of a different scenario, doing a better around anchoring by asking a lot of questions concerning the numbers and asking people to justify their conclusions can as well work. Another application is to help individuals improve their decision making.  As compared to ranking options, it is critical to look at the individual issues and then to consider all options only at the end before making a decision. This ensures that System 2 is involved in the decision making process.

The book also brings out the role of statistics in financial decisions. Financial activities should greatly rely on financial statistics. Such statistics bases their calculations on market factors, profitability and other variables that influence the decision making process. Both individual and firm decisions should rely on a reliable measure as compared to intuition. Given the riskiness of investments, statistics is critical in many aspects of finance.

For organizations, better quality control over decision making within firms is critical to the survival of the firm. For example, a manager can ask all participants to write down their opinions before issues are discussed in meeting. Organizations and individuals can also overcome the overconfidence bias by using a different technique in a situation where important decisions have to be made but not yet implemented.  In other words, Kahneman suggests that it is imperative to legitimize dissent to improve decision making in an organization. For example, many individuals’ investors use the Beta to determine the risk of an investment in the market. In conclusion, it is impossible to take the human element out of human decisions, but an understanding of how the human mind works can help to ensure that better investment decisions are made.

Conclusion

Many investors probably make mistakes, not realizing errors until it is too late, as relatively few of us financial professionals or unbiased thinkers. However, there are various things individuals can do with the knowledge gained from behavioral finance.   The author explores multiple topics in behavioral economics including the substitution heuristic, prospect theory, and the framing effect. We are prone to over-estimate the probability of common events and accept uncritically every suggestion when we rely on system 1. System 1 is responsible for filling in ambiguity with automatic guesses and interpretations and rarely considers other interpretations. While System 1 makes a mistake, System 2 jumps may consider alternative explanations. Thus, The Halo effect also plays a role in making decisions. The problem is that our intuitive judgments are impulsive and does not critically examine our thoughts clearly. It is critical to remind System 1 to stay objective and resist jumping to conclusions and hence enlist the evaluative skills of System 2. According to Kahneman, traders agitate because they tell themselves coherent stories. However, even Fortune 500 CFOs tell themselves stories that are coherent and not justified by facts. In fact, CFOs at Fortune 500 firms may be overconfident than CFOs of smaller firms. As finance professionals, we need to stay focused on hard data before us and not lean on information based on impressions or intuitions. We should combat overconfidence by basing our beliefs on critical thinking as opposed to subjective feelings. This way, we can understand how the human mind works hence ensure that we make better investment decisions.

Carolyn Morgan is the author of this paper. A senior editor at MeldaResearch.Com in paper college 24/7. If you need a similar paper you can place your order from custom nursing papers.