Daniel Kahneman, Professor Emeritus at the Woodrow Wilson School of Public and International Affairs at Princeton University, delivered an address to the 65th Annual Chartered Financial Analyst conference in Chicago today. Kahnemen, a Nobel laureate in 2002, discussed the psychology of behavioural finance, focusing on how confidence and psychological associations drive financial behaviour.
Kahneman opened with discussion around system one and system two thinking, or in other words, the difference between basic thinking or reactions and in depth analysis. With this in mind, he discussed how “system one” thinking drives associations and prepares individuals for thinking in a certain context. Hearing or reading about certain words that an individual has developed associations with over time will encourage that same individual to think within a defined context, even when dealing with potentially unrelated concepts soon after these anchors have been raised in their mind subconsciously.
In applying this to trading or investing, it’s easy to see how confidence can rise within an organization when individuals are understanding news and market events in the context of other positive developments. Kahneman gave an example of the capture of Saddam Hussein, which he claimed that Bloomberg insisted was the cause of both the morning rally and the afternoon collapse in stock markets on the day that news hit the markets. It is clearly unlikely that such news could be the driver between both the increase and decrease in stock valuations, but the authors at Bloomberg had associated that news within the context of the market direction and subconsciously attributed this news to the direction of the market.
When it comes to these associations, or “anchoring,” Kahneman cautions that investors need to slow down and think deeply about critical decisions when the answers seem to come more quickly. Perhaps more valuable, in using quality control over decision making, firms and investors can look at the process around a decision and whether this process is likely to create associations or biases that may lead to a poor decision. It is easier to examine decision making processes objectively than trying to directly examine subconscious biases on the individual level.
Through careful reflection on how we come to the decisions we make, investors and organizations can dramatically improve the decision making process and therefore the outcome of the choices that are made.