Many often associate rational thinking with investing. However, cognitive biases are in fact widespread amongst investors, limiting their ability to make the optimal decisions. In this article, I share three lessons from Daniel Kahneman’s “Thinking Fast and Slow” that we investors can learn from.

1. The Illusion of Understanding

In his book, Kahneman explains that we humans are prone to suffering from the illusion of understanding. The core of this is that we THINK we understand the past and therefore, can foresee the future. When in fact, we actually understand less than what we think and discount the role of other factors such as luck. In hindsight, we can all agree that Google was a sure success. Two computer science students from Stanford creating a superior search engine. Yet, the founders wanted to sell Google for 1 million at some point, only for the buyer to decline the offer because they think the price was too high. The lesson here is that we should not place too much weight on predictions, especially if they were made by looking at the past. People often overestimate their ability to do things and this applies to analysts and economists as well. By studying how markets perform in history, they think that they can predict when the next crash can occur. In doing so, they fail to recognise that many things are in fact left to chance.

For instance, many analysts have been warning of a stock market bubble since last year. Yet, the S&P500 year-to-date gain is 22.8%. Had we suffered from the illusion of understanding and stayed out of the stock market, we would have incurred huge opportunity costs in terms of potential gains forgone. Thus, don’t let these noise affect your decision making and paralyze you.

There are many ways to manage your emotions. First, do not see whether to invest or not to invest as a binary decision. Think of it as a spectrum. If you think there is a chance that the market will crash soon but are not 100% sure (as no one can be), maybe start by investing 30% of your money you plan to invest and dollar cost average the rest over the coming months. Dollar cost averaging is an excellent method to remove emotion from the decision making process. By investing $200 every month like clockwork, your emotions will not get in the way of decision making.

2. Risk Policies

The next lesson is related to Risk Policies. Read the following and make a decision for BOTH i and ii.

Decision (i): choose between

A. Sure gain of $240

B. 25% chance to gain $1,000 and 75% chance to gain nothing

Decision (ii): choose between

C. sure loss of $750

D. 75% chance to lose $1,000 and 25% chance to lose nothing

When faced with the above two decisions, people tend to choose A for decision (i) and D for decision (ii). Instead, when you look at things from the broader perspective, you realise how irrational we are.

A and D: 25% chance to gain $240 and 75% chance to lose $760

B and C: 25% chance to gain $250 and 75% chance to lose $750

At the heart of this is that humans are naturally risk averse when dealing with gains and risk seeking when dealing with loses. The above experiment substantiates how this can lead to suboptimal outcomes.

The lesson for investors here is that looking at the bigger picture will allow you to make better decision for your portfolio. Do not view each investment individually. Instead, review your portfolio as a whole. No matter how much you know about each business, there is always a chance that things do not go according to plan. Therein lies the case for diversification. Even if there are multiple losers in your portfolio, all you need is one or two big winners to make a worthwhile return (as long as the loses are small and gains are larger). In value investing, we always seek for capital preservation. Which involves careful study of the company’s fundamentals in order to limit our downside. More on value investing philosophies here.

3. Mental Accounts

The third lesson is on mental accounting. Mental accounting refers to the different values a person places on the same amount of money, based on subjective criteria, often with detrimental results. Essentially, we tend to compartmentalize things when making decisions and this often leads to suboptimal decisions being made. Consider the following thought experiment:

Imagine you require money to buy a house. And you own 2 stocks, one is a winner: currently worth more than what you paid. The other is a loser. Which will you sell?

Most investors will sell the winner and add a success to his record. This is because if he chose to sell the loser, he would add a failure to his record.

This is mistake that afflicts individual investors when they sell stocks from their portfolio. As Peter Lynch once said “Selling your winners and holding your losers is like cutting the flowers and watering the weeds.” The lesson here is that you should not sell your winners and keep your losers because you don’t want to realize loses. If the winning stock is still undervalued, you will be missing out on a lot of gains by selling it early. Likewise, the losing stock may remain a losing stock due to various reasons. You could have missed out something or the company fundamentals have deteriorated.

Of course, the caveat here is that there are some scenarios where you should sell your winners (when its price is irrationally high) and buy the losers (when the fall in price has nothing to do with its fundamentals). Thus, always fall back on the business fundamentals and not how the stock price has performed in the previous months.

These are merely three lessons for investors from “Thinking Fast and Slow” and is by no means exhaustive. In his book, Daniel Kahneman also tackles other heuristics and biases. It is a book filled with wisdom and countless lessons for life and more. It is a book I will definitely recommend to anyone who wants to learn more about the human mind and how decisions are made. If you are interested in learning more about investing, check out my other article on 7 Timeless Concepts From “The Intelligent Investor”.