The Two Things That Are Holding You Back
Daniel Kahneman is an Israeli psychologist and economist with expertise in the field of behavioral economics. Kahneman has spent a lifetime studying the human brain and how it functions, especially in financial decision-making. In fact, in 2002, he won the Nobel Prize in Economics for his work.
In his book, Thinking, Fast and Slow, Kahneman explains how our brain operates according to two different systems – one automatic and the other more thoughtful and considered.
SYSTEM 1 (fast) –
It operates automatically and involuntarily; it is unconscious, can’t be stopped, and runs continuously. We apply it effortlessly and intuitively to everyday decisions, e.g., when we drive, recall our age, or interpret someone’s facial expression.
SYSTEM 2 (slow) –
When necessary, it’s only called upon to reason, compute, analyze, and solve problems. It confirms or corrects System 1 judgment, which is more reliable but takes time, effort, and concentration.
System 2 acts as a check and balance on System 1, and when the two are working in unison optimally, we make our best decisions. The problem is that System 2 often gets overloaded. When we’re called on to make snap judgments in System 1, we’re often influenced by biases that cause irrational behavior and poor decision-making.
“We humans constantly fool ourselves by constructing flimsy accounts of the past and believing they are true.” -Daniel Kahneman.
Kahneman hypothesizes that we distort memories of our past – even lying to ourselves – to shape our perception of reality, which shapes our views of the world and our expectations of the future and not always in a good way.
This distorted perception of our past leads to irrational behavior and faulty decision-making. The problem with this defect in our perception of the past is we often magnify the negative experiences in our minds while minimizing the positive ones.
This disparate weighing of negative and positive experiences is the basis of Kahneman’s Prospect Theory, a theory of behavioral finance that describes how individuals make investment decisions based on the prospects of gains and losses.
In weighing those prospects, individuals often act irrationally – giving more weight to potential losses than gains. In other words, assigning more weight to potential losses prevents us from pursuing potential gains even when the odds are exactly even. When we give more weight to the 50% chance of losing $1,000 than the 50% chance of gaining $1,000, we magnify in our minds that chance of losing $1,000 to the point it feels like losing $10,000, which prevents us from ever taking that chance even though in reality, the odds are even.
The Prospect Theory, boiled down to its essence, is this:
The potential pain from the prospects of a loss outweighs the potential joy from the prospects of a gain, and this is what holds back many investors from taking a leap of faith to try something new. This loss aversion is what prevents many investors from making rational investment decisions.
The Prospect Theory says our fear of pain and the motivation to avoid losses culminate in our perception of our pasts and family and societal customs and practices that have taught us to play it safe when investing.
That’s why trillions are poured into diversified mutual and index funds. Wall Street markets are “safe” to prey on investors’ fears. But “safe” isn’t going to make you rich. It might not even cover inflation these days.
Savvy investors have learned to block out their biases to focus solely on the present and present opportunities. They prevent breakdowns in communication between their System 1 and System 2 cognitive machines.
By blocking out prejudices in their pasts, they can evaluate each opportunity on its own merits and not let irrational biases creep into their investment decision-making. This allows them to gravitate towards alternative investments that allow them to achieve above-market risk-adjusted returns, although the rest of the world calls them risky.
What about you?
Is the fear of pain and loss preventing you from considering alternative investment options?
Maybe it’s time to reevaluate your perceptions and reset your decision-making process to free Systems 1 and 2 of your brain to function correctly and efficiently to allow you to make rational and wise decisions – especially when it comes to your investments.