In Memoriam: Daniel Kahneman

Dear investors,

Last week, Daniel Kahneman passed away at the age of 90. A professor of psychology at Princeton and one of the pioneers of behavioral economics research, Kahneman challenged the classical economists’ premise that people always make economic decisions rationally. For his academic work, he was awarded the Nobel Prize in Economics in 2002 and remained an influential thinker until the end of his life. In 2011, he published his book “Thinking, Fast and Slow,” a worldwide best seller bestseller.

Kahneman’s work gained great prominence among investors for mapping what are known as cognitive biases: tendencies of the human mind to, in certain situations, deviate from pure logic and make poor economic decisions. Every experienced investor recognizes how the emotional side can affect investment decisions and lead to undesirable outcomes. Understanding how human psychology relates to the investment process and striving to minimize the influence of cognitive biases on one’s own decisions is therefore essential.

We have touched on this topic on several occasions, but it is so broad and relevant that there is always more to say. We aim to share here some of the knowledge developed by Kahneman that has contributed enormously to our investment analysis processes.

Two Systems in One Mind

Our brains operate in two quite distinct modes. The first, called by psychologists simply System 1, is responsible for our fast and intuitive reasoning. It is automatically active at all times, requires no particular effort on our part, and we have no voluntary control over it. It is this system that recognizes familiar people, coordinates our everyday movements, perceives dangerous situations, and decides in fractions of a second how to react to them.

The other is System 2, responsible for the sophistication of the human mind that we properly understand as rationality, capable of processing information and abstract concepts in a methodical and logical way. In contrast to this greater sophistication, System 2 is slow and requires a conscious effort to focus on a specific problem for as long as necessary to solve it. It is this system that performs mathematical operations, analyzes complex situations, and carries out academic activities in general.

Each of these systems has its practical utility. System 1 handles most of our everyday decisions, which would be impossible to make through directly analytical methods. Imagine driving to work having to explicitly calculate the ideal steering wheel angle for every turn along the way. This is the best system for all cases where it makes sense to sacrifice precision for speed. It is sufficient for the act of turning a car’s steering wheel to be approximately correct, and speed allows for corrections as the movement unfolds, so the intuition of an experienced driver works perfectly well in this situation.

System 2, on the other hand, is what allows us to transcend the level of animal intelligence and achieve uniquely human feats. Despite being slower and harder to use, it is what enables us to perform calculations sophisticated enough to launch a satellite with the precision required to place it in Earth’s orbit — something virtually impossible to accomplish intuitively.

The problem with the existence of these two distinct operating modes is that they sometimes act simultaneously in conflicting ways — that is, they reach different conclusions. This is the primary source of cognitive biases. The easiest way to understand the nature of a cognitive bias is through an analogy to optical illusions. In some situations, your brain interprets images incorrectly. One example is the image below, where two lines of exactly the same length appear to be different sizes because of the shape of the arrows at their ends. If in doubt, feel free to measure both lines.

System 1 is what perceives the lines as having different lengths. System 2 is what understands the error and accepts the evidence that the lengths are equal after both are measured. Note that even after confirming that the lengths are equal, you continue to see the lines as apparently different sizes. This is the nature of the conflicts that arise from cognitive biases. Sometimes your instincts point in a different direction from your own rational analysis, and the proof that the analysis is correct does not change your instinctive perception — so making decisions based exclusively on the results of your analysis is not as easy as it might seem. It requires a conscious effort and a “vote of confidence” in the superiority of your System 2. It is at this point that many investors fail, follow their System 1 (which is always psychologically more comfortable), and end up making poor decisions — even when they have the intelligence and knowledge needed to devise a better course of action.

How Biases Act in Investments

In theory, investment decisions should be made according to the probabilities of gain and loss implicit in each investment opportunity. Whenever the statistics favored the chance of gains, an investment opportunity would be advantageous. However, pure mathematics rarely predicts the decisions people actually make in real situations involving the analysis of probabilities of gains and losses. Consider the following situations:

Which of the following would you prefer?

A. Receiving R$40,000 with certainty

B. Fliping a coin. If it lands heads, you win R$100,000. If it lands tails, you win nothing

The vast majority of people prefer the certainty of gaining R$40,000, even though it is the mathematically less advantageous option, since the expected value of option B is R$50,000 (50% × R$100,000).

Now consider the reverse situation. Which would you prefer between?

A. Losing R$40,000 with certainty

B. Flipping a coin. If it lands heads, you lose R$100,000. If it lands tails, you lose nothing

Would you now prefer to flip the coin and rely on luck? Most people prefer option B in this situation. Note that the mathematics involved is very similar, so there is a logical inconsistency between preferring option A when the problem involves gains and option B when the same problem involves losses. Yet people consistently make decisions in this way.

It was by studying this type of inconsistency in decisions involving probabilistic analysis that Daniel Kahneman and Amos Tversky, his research partner, developed Prospect Theory. The key finding is that people feel the impact of gains and losses differently: losses are felt more intensely than gains of the same magnitude. Under this asymmetric perception of gains and losses, people are instinctively more risk-averse in situations involving potential gains and accept greater risk when the situation involves potential losses.

Anyone who has ever invested directly in stocks has probably felt the effect of this bias in the following situation: when you buy a stock and it rises significantly, the instinctive response is to want to sell it to lock in the profit earned so far. When the stock falls, the instinct is to want to hold it until the price returns, at least, to what you paid for it.

Another bias identified by Kahneman and Tversky is that the perception of economic value is not associated solely with the absolute value itself, but with the change that value represents in total gain or loss. The larger the gain or loss already accumulated, the smaller the emotional impact of an additional gain or loss. For example, if the profit on an investment goes from zero to R$50,000, the feeling of gain will be much greater than if you already have a profit of R$500,000 and it increases to R$550,000, even though the additional gains are exactly the same.

In investing, this second effect compounds the harm of the first. When a stock rises, you tend to undervalue the chance of it rising a little more and prefer to sell quickly. When it falls, you tend to see less harm in watching it fall a little further and prefer to hold on in the hope that it will recover. As a result, investors sometimes sell good investment theses too early — and commonly watch the stock rise well beyond the price of the premature sale — and continue to hold stocks that no longer have good return prospects for longer than would be reasonable, hoping to avoid the psychological pain of crystallizing the loss.

These are just a few examples from the long list of cognitive biases identified by Kahneman. For those who wish to read more on the subject, we discussed other biases relevant to investment decisions in our letter "The flaws of the human mind”, from April 2022. However, the best source is the book “Thinking, Fast and Slow” itself, a read that is not only useful, but also quite enjoyable.

How to Handle Biases in Investments

We have already noted that, just as optical illusions are unavoidable, it is impossible to temporarily switch off your System 1 so that the cognitive biases it causes disappear. Even Kahneman, after decades dedicated to studying the field, admitted he had never managed to eliminate his own biases. So what can be done to avoid cognitive errors in investment analysis? Here, we will combine Kahneman’s recommendations with our own experience.

Identifying the action of cognitive biases in real life is already a less obvious task than it may seem at first glance, because when an important decision is to be made, those involved typically focus on the subject of the decision itself, not on the possible cognitive flaws their own minds may be subject to while thinking about it. Mitigating the chances of cognitive failures therefore requires a series of measures.

The first step is to study the cognitive biases that can interfere with investment decisions and the situations in which they typically manifest, as it is very unlikely you will notice them without having a clear picture of the behavioral pattern you are trying to identify.

The second step is to make a conscious effort to remain vigilant to possible biases during real decision-making processes. Your memory will not always be complete and reliable enough for you to identify the biases that tend to interfere in your own decisions by recalling past situations. This exercise is easier when working as a team, as biases tend to be more easily identified by an outside observer than by oneself. Each person is more susceptible to certain biases according to their personality, and knowing which ones they are helps considerably in mitigating their effects.

The third step is to structure a formal investment analysis process that makes it easier to maintain the rigor and discipline necessary for each decision to be as rational as possible. An excellent practice is to record all relevant points of each analysis in writing. Not only to maintain a history of analyses and be able to evaluate successes and failures in retrospect, but also because writing enhances the capacity for structured thinking. Just as it is far easier to perform mathematical operations on paper than in one’s head, it is more effective to carry out complex qualitative analyses by writing out each step of the reasoning rather than relying purely on memory.

Even with a well-structured analysis process, perpetual attention is required to execute it with discipline. Since the predominance of System 2 depends on a conscious effort, all it takes is a moment of inattention for System 1 to take over and introduce some bias through reasoning shortcuts that, in the moment, will probably seem entirely appropriate.

The Target Nobody Could See

Kahneman’s contribution was so significant because it brought clarity to a field filled with subjectivities and conflicts with classical economic doctrine. The premise that intelligent and qualified people would make economic decisions in a purely rational manner survived so long in academic circles because it is, in fact, quite reasonable. What is surprising is the realization that, in reality, things are not that way.

The very notion that our instincts can lead us to wrong decisions is not obvious. Popular culture points in the opposite direction, portraying intuition as something that surpasses rationality and points us in the right direction in the most difficult moments. The stereotype of a great investor in films is even that of someone who follows their instincts with courage and boldness, making big bets that quickly bring them fortune. The truly great investor tends to be almost the opposite: someone who doubts their own instincts, analyzes each opportunity methodically, and does everything possible to prevent their emotional side from influencing their decisions.

“We all think we are far more rational than we really are. And we believe we make our decisions because we have good reasons for them. Even when it is the opposite. We believe in the reasons because we have already made the decision.” Daniel Kahneman