I read Thinking Fast and Slow and wanted to share the ways this book helped me make better investment decisions

Strictly speaking, Thinking Fast and Slow is not an investing book, but I've seen it referenced and quoted so many times in other investing books that I simply had to go read it for myself. I'm very glad to say that I had not wasted my time and this is an excellent book on all aspects of decision making. Daniel Kahneman is the foremost expert in the field of decision-making and judgement, even receiving a nobel prize in 2002 for his contributions to the field of behavioural economics. Kahneman covers a lot of ground in this book, but for the purposes of this post, I'll be focusing mainly on what he has to say about our money decisions.

• Anchoring

The anchoring effect is the tendency for a given number to affect people's estimation of an unknown value, regardless of whether the given number resulted from a dice throw or in-depth calculation.
Kahneman and his research partner Amos Tversky rigged a wheel of fortune to only land on 10 or 65.

Then they invited university students in for an experiment. First, they spin the wheel, then had the student write down the number it landed on. Afterwards, Kahneman and Tversky asked the students "Is the percentage of African nations among UN members larger or smaller than the number you just wrote? What is your best guess of the percentage of African nations in the UN?" Students know that the number was produced by random, the written number should not have any influence on the students' estimation of African nations in the UN. Yet on average, those students who got 10 estimated 25% while those who got 65 estimated 45%.

In the instance of estimating the intrinsic value of a stock, we are similarly persuaded. The given number (stock price) will inevitably influence our estimation of the stock's true worth unless we're exceedingly wary. It's for this reason that overpriced stocks look attractive while underpriced stocks look risky. Despite the fact that we should not let the actual price of a stock influence our calculation of its intrinsic value, most of us can't help but do so due to the anchoring effect. For example, imagine you have a normal plastic bag. If asked, we might say it's worth a nickel at most. However, if the store priced the plastic bag at $1000 and hundreds of people purchased it for that price, we might be persuaded that the plastic bag is worth more when it's not.

• Overconfidence

System 1 is unconscious and therefore, it isn't able to second-guess and self-evaluate its judgements. Paired with a lazy System 2, it's only too easy for people to form beliefs that lack evidence. Confidence, contrary to what our intuition says, is not an indication of correctness. In fact, the more confident we are, the more vigilant we should be. In the case of investing, it's important not to be led astray by overconfidence, both your own and that of investing professionals.

Given the danger and prevalence of overconfidence, Kahneman offers us a thought experiment called the postmortem to help diminish the tendency. Postmortem is where you imagine that the project you're about to embark upon or the business you're about to invest in had failed 15 years down the line. You then take 5-10 minutes to brainstorm how this might have happened. In performing this exercise, you inoculate yourself against overconfidence and create opportunity to pre-empt future mistakes.

• Loss Aversion

At the core of many of our poor money choices lie loss aversion. The idea is that most people feel the loss of something far more acutely than they feel the gain. Through his research, Kaneman found that the ratio of loss aversion measures out to 1:2 or 1:1.5 on average. This means you must earn $200-$150 to offset the psychological pain of losing $100.

Although it's reasonable to protect wealth more fiercely than pursue gains, many people are loss averse to the point of irrationality. When faced with an offer of "pay $400 for 95% chance to win $1,000" OR "pay $700 to win $1,000 for sure" most of us would go with the second option. Objectively speaking, 95% chance to win $600 is an excellent deal, yet we are willing to pay a hefty premium to eliminate the negligible chance of losing money.

To resolve this in-equivalency Kahneman recommends taking a broadview perspective when investing. We are not making a single investment, we are making a number of investments that will average out. Waiting until we come upon an opportunity that offers 100% guarantee to make money means we'll never invest at all. It may also mean we end up relying solely on bank deposits with returns that fail to keep up with inflation, an inevitable result of loss. Yes, it's likely that some investments will come out at a loss, but as long as you make more good investments than bad, your net result will follow the trend of probability. Meanwhile, if you shy away from good deals, these missed opportunities will gradually accumulate into a big loss.

• Attitude to Risk

In Kahneman and Tversky's Nobel Prize-winning theory called Prospect Theory, they posited that just as there are diminishing returns for gains, there is a similarly diminishing impact for losses.

Kahneman offers two illustrative problems to explain prospect theory:
Problem 1: Which do you choose?
Get $900 for sure OR 90% chance to get $1,000
Problem 2: Which do you choose?
Lose $900 for sure OR 90% chance to lose $1,000

As mentioned in the previous point on Loss Aversion, most people would much prefer to get $900 for sure for Problem 1. What's interesting is that this situation is entirely inverted in Problem 2. All of a sudden, people would prefer a 90% chance to lose $1,000 over a guaranteed loss of $900.

The reason is because going from $900 to $1,000 is an insignificant increase in psychological value and the 10% risk of getting nothing at all is a huge loss. We are unwilling to put $900 on the line for a chance to gain an additional $100, even when the odds of success is 90%. When it comes to gains, we are risk averse.

Meanwhile, going from a sure loss of $900 to a potential loss of $1,000 is precisely the opposite. If we are guaranteed to lose $900, the loss of an additional $100 feels negligible. In exchange for the possibility of losing an additional $100, we gain a 10% chance to lose nothing at all, which has much greater psychological value. When it comes to losses, we are risk seeking.

Why is this important?

Consider we purchased a stock for $80 a share and it has gone down to $30. We know the company is performing poorly and the economy is entering a recession. The odds that the stock will drop to $20 and stay at that price is 90%. The smart decision is to sell the stock at $30 and reinvest in another stronger company, but because we are risk seeking when faced with loss, we hold on to the stock for that slim 10% chance that it will bounce back to $80 a share. This is the reason why we hold on to losing stocks and refuse to realize a loss. Selling now and losing $50 for sure feels much worse than a 90% chance to lose an additional $10 and a 10% chance to make it all back.

​

The good: This book is full of excellent psychological concepts presented alongside compelling examples, both in the form of theoretical thought experiments and actual experiments conducted by experts. Kahneman not only taught me lots of new psychology concepts but also explained familiar concepts (priming, availability heuristic, loss aversion) in a new way so I had a truer, deeper understanding. This book will be of great use to anyone who makes decisions on a regular basis.

The bad: As you can imagine, this book goes very fast, especially in the later chapters. It sometimes felt like concepts that deserved its own chapter (or even its own book) are allotted only pages and paragraphs, which is a shame. This book also lacks a clear progression of ideas, it very much feels like a bunch of related but disparate concepts packaged together into a book.

Personal thoughts: I really enjoyed this book and I highly recommend it. It's a fairly long read (my edition was 499 pages) and at times rather dense, but it's well worth the time and effort. While writing this review I really struggled to choose which concepts to include and which to leave out because all of the ideas from Thinking Fast and Slow feels so fundamental to the way we make decisions.

If you've read this book too, I would really appreciate it if you drop a mention of something from the book I wasn't able to cover because goodness knows there are a lot.