Princeton University psychology professor Daniel Kahneman was awarded the Nobel Memorial Prize in Economic Sciences in 2002 for a series of studies popularized in his book Thinking, Fast and Slow. Prof. Kahenman's work showed that the human brain has two separate systems for thinking and problem solving, and this has profound implications for investors.
Most of the time, we are 'thinking fast,' using what Mr. Kahneman called heuristics – rules of thumb that simplify problems allowing for quick reactions. The brain does not like using the process, "thinking slow" – higher analytical functions such as mathematic or accounting skills – because it takes a lot more effort, both in terms of intelligence and concentration.
The applications of this thesis to investing are too numerous to count. Investors that are chasing rallies, for instance, are thinking fast, using a psychological heuristic that makes people feel safer in groups. Deep value investors that go through every footnote in 10 years of a company's financial reports, on the other hand, are thinking slow.
There are more dangers for investors in thinking fast – almost by definition the process involves the oversimplification of market risks – but both can be effective. As a personal example, I successfully used a heuristic in recommending investors add U.S. dollar assets in 2013. The S&P/TSX composite index had outperformed the S&P 500 (in Canadian dollar terms) for the longest period in history. Once metals and mining stocks started wobbling, it was easy to apply the "what goes up must come down" rule of thumb in terms of the domestic market's outperformance.
The investing benefits of thinking slow are relatively obvious. Careful analysis of the economic, financial, and corporate factors that drive equity terms is the best way to manage risk and generate returns.
The important thing for investors is to recognize when they are thinking fast, and what heuristic they are using to make decisions. Some psychological rules of thumb – such as the adrenalin surge of a "fight or flight" reaction – are much better suited to an evolutionary past hundreds of thousands of years ago and result in decisions that increase portfolio risk. When to allocate brain power to thinking slow is also important, and a vital component of successful investing.