Daniel Kahneman was a psychologist, but won a Nobel prize in economics and when he died last week the global investor community bemoaned the tragic loss as much (if not more) as any other community. What is the link here?

In one of his earliest television interviews decades back, a young Warren Buffett, when asked what is the most important quality for an investment manager, responded, ‘it’s a temperamental quality, not an intellectual quality. You don’t need tons of IQ in the business. You need a stable personality.’ He explains how you are not  right or wrong, just because a thousand people agree or disagree with you, but you are right because your facts and reasoning are right.

Daniel Kahneman brought this to the attention of investors. He became famous for spotlighting how overconfidence and illusions veiled underlying poor reasoning and unstable personalities in most investors. Entrenched human biases, and consequently poor reasoning, influence investing decision to buy and sell stocks, negatively impact portfolio and, in many cases, even cause extreme distress.

Staying put in stocks past their prime when business is disrupted and on the decline, excessively averaging poor quality stocks as they keep trending down (akin to catching a falling knife), leveraging heavily to invest in stocks to get rich quickly, ploughing more than you are willing to lose in F&O trading — all these are examples of biases and poor reasoning in investing.

In his widely popular and bestselling book, Thinking, Fast and Slow,  Daniel Kahneman explains very articulately the two systems in our brain that govern our decision making —  System 1 and System 2.

System 1 is fast, automatic, subconscious, intuitive & instinctive, based on heuristics, biases, etc. System 2 is slow, conscious, analytical, objective, controlled and based on critical and logical thought. Both have their purpose and are important. For example, when you are crossing the road or driving a car and there is another vehicle overspeeding in your direction,  you need to take spontaneous decisions, and you need to function based on System 1 decisions there.

If you take time to analyse and do mathematical calculations on the distance and speed of the approaching vehicle, your response may be too late and may be even fatal! So, intuition and reflexes have an important role to play in our lives.  

The problem in decision-making arises when we apply System 1 to areas in which System 2 needs to be applied. Sometimes we tend to be instinctive and quick in picking stocks instead of taking a System 2 approach and fall prey to our cognitive biases. In the book, Kahneman elucidates on many of the biases human beings are prone to, which will impact our stock-picking decisions also. Some of them are:

Hot hand fallacy

Hot hand fallacy is extrapolating recent years performance to the future. How many extrapolated the performance of best performers in previous decade bull market to post-Covid bull market! But the winners of that era — FMCG stocks, high quality private banks, paint stocks — have been painful underperformers in the bull market of last four years.

Experts too fall prey to this as evinced by developed market central bankers incorrectly terming inflation as ‘transitory’ during most of 2021. This was rooted in what they had witnessed in decade-long era since global financial crisis when deflation was the problem they faced and not inflation. Extrapolating this to post-Covid economy was a big mistake rooted in this bias. The pain of that error is felt by consumers there even today.

Base rate fallacy

This refers to a fallacy where individuals tend to ignore statistical and other widely-prevalent evidence, in favour of only new or recent information they have been exposed to. Consider these two cases – One, a finfluencer stands in front of a luxury car and says how anyone can make money and become rich in F&O. Two, hard statistics indicate 9 out of 10 participants lose money in F&O. Why do most ignore this statistic and get aggressive in F&O trading? Base rate fallacy explains such illogical decisions we make. What we see amongst the successful people influences us more.

If people were shown videos of those who had to sell their luxury cars or home to pay for F&O losses, will it make new entrants think before entering F&O? And if they enter, will they be disciplined and stick to stop loss rules? It might. But unfortunately ‘9 out of 10’ is just a statistic for now.

Loss aversion

According to the ‘Prospect Theory’ research published by Daniel Kahneman and his research partner Amos Tversky, the pain of losing is psychologically about twice as powerful as the pleasure of gaining. As per this, in general we all try to avoid losses. However, when we invest based on System 1 thinking and experience losses, our emotional responses are stronger and may result in more biased decision-making. Averaging poor quality stocks as they fall instead of booking your losses and buying a better stock, pouring more money into F&O even after heavy losses — are examples of this. Losses cloud our thinking, and we fail to see there are alternative good investments out there to consider, instead.

Illusion of validity

This refers to the overconfidence we have in our predictions. This is the bane of many poor investment decisions. In general we tend to have high conviction when we take initial positions in stocks. If you have spent over a decade in stock markets, you would have realised that even a lifetime is not enough to master it, the markets keep evolving and the learning is never-ending. The fact is, you can never be sure as there are numerous factors – company-specific and macro-economic that you cannot predict with certainty.  

Many a time there is a high conviction in stocks based on just one aspect you see, for example -  Low valuation/PE. Even the experts and investing legends got trapped in this when it came to stocks like Satyam Computers and Dewan Housing Finance Limited. Low valuation and both companies’ successful past lured investors. But prediction based on these data was awry. At macro level there are multiple times more factors that we cannot fathom. So, making high-conviction predictions and investing decisions based on the illusion of validity is risky.

According to Kahneman, our System 1 is designed to jump to conclusions from little evidence.

Anchoring bias

The way you assess anything is in some way linked to the first reference point you had on it. If you have a stock in your portfolio, for taking a decision to buy more or sell it,  do you assess it purely on its valuation and future prospects, or also on the price at which you entered? If you missed a stock when it was very low, but became a multibagger later, is your decision to buy it, or not, now influenced only by its current merits,  or also influenced by the fact that you could have had it so cheap earlier? Does it play in your mind? Similarly, does the decline in a stock price from its all-time highs influence your investing decision?

When you try to find answers to these, you will be able to appreciate the underlying anchoring bias in investing decisions.

These are just a few of the many underlying biases that Kahneman and many other eminent psychologists have made us take note of.

Can we address these and become better investors? While there are a few critical views that being aware of biases may not necessarily free our decision making from being influenced by it, it may vary for individuals according to the process and discipline they bring to their investing approach. In one of our upcoming bl.portfolio editions we will explain how we can use the System 2 approach to weed out biases, for better stock-picking.