Understanding Behavioral Science

How We Think Affects How We Invest

Understanding how we think can help us become better decision makers and better investors.

WHAT MAKES US TICK: THE TWO MODES OF THINKING

When making important decisions, do you rely more on intuition or analysis? It’s an important distinction, because understanding how you make decisions can help you make better choices. One way to understand how we make decisions was brought to the forefront in Daniel Kahneman’s landmark book, Thinking Fast and Slow. In it, Kahneman posits that decision-making is not entirely based on conscious, rational thought. He outlines two distinct modes of thinking: “System 1,” which is instantaneous, driven by instinct and prior learning; “System 2,” which is slower, driven by deliberation and logic. The rub is that even when we think we’re making decisions based on rational considerations, our System 1 beliefs, biases, and intuition drives many of our choices.

SYSTEM 1: YOUR INTUITIVE MIND

Have you ever driven on “autopilot” or without any memory of the trip itself? If you’re a veteran driver, you’ve probably experienced this on routes you take often, like your commute to work, or a trip to the grocery store. This is not an operation that demands strategic thinking; traveling this route is a previously learned behavior. Your System 1 thinking, which includes deeply embedded memories, is doing all the work. Kahneman categorizes System 1 as “fast-thinking” for good reason. It’s thinking that’s done automatically or instinctively with almost no effort. System 1 is what we use to answer simple equations like 2+2, or how we know that the second part of the phrase “bread and …” is butter. It is powerful and intuitive, but also emotional, impatient and impulsive.

Incredibly influential, System 1 affects almost all of our decisions, and we rely on it much more than we realize. It’s the system we use most – it’s efficient and generally makes decisions before we’re even aware of them. The downside to System 1’s influence is that it pays no attention to what it doesn’t know. Think of it as our mental system for jumping to conclusions – and as such, it’s prone to biases and systematic errors. When we allow System 1 to make decisions that we should be passing on to our slower, logical System 2, problems arise.

SYSTEM 2: YOUR ANALYTICAL MIND

If System 1 is fast thinking, System 2 is slow thinking. It’s rational, methodical and cautious. System 2 kicks into gear when more complex thinking is required. Consider it this way: If System 1 drives you to work on “autopilot,” it’s System 2 that enables you to maneuver your car into a tight parking space when you get there. It requires us to take a step back and be more conscious in our thinking. The downside is that System 2 is slow and requires effort, which makes trying to solve multiple complex problems at the same time challenging if not impossible.

For example, while walking at a leisurely pace (a System 1 activity), you could likely work through and solve 17x24 (a System 2 activity). However, if you picked up your pace and started to jog, you’d be a lot less likely to solve the same equation. This is because jogging requires a more conscious effort; it shifts the focus of System 2 and makes the complex problem harder to solve. Importantly, the more System 2 takes on, the more energy it expends, and System 2 attempts to save energy by doing as little work as possible – it’s powerful but lazy.

How We Think Affects How We Invest

HOW THE TWO SYSTEMS WORK TOGETHER

While it may seem that System 2 is the dominant system, System 1 is actually the hero here. It’s in charge roughly 95% of the time. But, because System 1 is lightning fast, it inevitably runs into problems. In these situations, System 2 steps in for support. By design, System 2 monitors the thoughts and actions that System 1 promotes and can also control them by encouraging, suppressing or modifying behaviors. In normal circumstances, System 2 can override System 1, but if System 1 is highly emotional or System 2 is tired or preoccupied, then it will fail to control System 1.

HOW SYSTEM 1 AND SYSTEM 2 RELATE TO INVESTING

System 1 is good at judging simple, repetitive tasks and finding patterns. What it doesn’t excel at is processing new or complex information, and it’s where your biases tend to be stored – none of which make for strong investment decisions. Unfortunately, we tend to fall back on our intuition and System 1 thinking when making investment decisions, when we should actually slow down and consciously focus on engaging our analytical System 2. Remember that when making investment decisions, our first impulse is not necessarily the correct one. Below we highlight two common biases that can derail investors’ long-term objectives.

OVERCONFIDENCE CAN HURT

Investors often look for patterns in previous market cycles and feel that identifying past patterns will inform how the future will look. However, our knowledge of the past is imperfect at best. Our minds generally don’t fully account for the role of chance and therefore may falsely assume that a future event will mirror closely a past event. As such, we have a tendency to exaggerate our ability to forecast the future, which fosters overconfidence. And in terms of its consequences for investment decisions, overconfidence may well be the most significant among biases.

Overconfident investors tend to underestimate risk and feel that they’re better than others at picking the best securities or strategies and when to enter or exit a position – a behavior that can lead to the wrong investments, excessive trading and suboptimal market timing – all of which can lower returns and derail your long-term investment goals.

BEWARE OF EMOTIONAL OVERLOAD

Market volatility, combined with a 24/7 news cycle, can unnerve even the most seasoned investors, but letting your emotional System 1 drive your investment decisions can have a huge impact on the outcome. Closely following daily market fluctuations may be a losing proposition, for example, because the pain of the frequent small losses exceeds the pleasure of the equally frequent small gains. Paying less attention to short-term outcomes and focusing instead on your longer-term goals can improve the overall quality of your investment decisions and outcomes.

While it may seem that System 2 is the dominant system, System 1 is actually the hero here. It’s in charge roughly 95% of the time. But, because System 1 is lightning fast, it inevitably runs into problems. In these situations, System 2 steps in for support. By design, System 2 monitors the thoughts and actions that System 1 promotes and can also control them by encouraging, suppressing or modifying behaviors. In normal circumstances, System 2 can override System 1, but if System 1 is highly emotional or System 2 is tired or preoccupied, then it will fail to control System 1.


How We Think Affects How We Invest

BEHAVIORAL SCIENCE IN ACTION

PIMCO has long understood that behavioral science can make us better investors. That’s why we’ve partnered with some of the best minds in the field at the Center for Decision Research at The University of Chicago Booth School of Business. Through this innovative partnership, PIMCO supports diverse and robust academic research that contributes to a deeper understanding of human behavior and decision-making. Learn more about how behavioral science can make you a better investor.

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