Berkshire Hathaway chairman Warren Buffett has said that high-speed trading contributes nothing to capitalism.Kim Kyung Hoon/Reuters
Psychologist Daniel Kahneman was awarded the 2002 Nobel prize for economics in an event that clearly underscores the importance of human behaviour in the financial world. Mr. Kahneman's research also fully supports, and to some extent underpins, the Berkshire Hathaway Not-Stupid school of investment strategy.
Stated simply, Mr. Kahneman's best seller "Thinking Fast, and Slow" provided a deeply-researched framework of a human brain that thinks on two distinct levels. One of them, thinking slow, is well suited to investing decisions. Thinking fast, on the other hand, will likely result in portfolio losses.
For the vast majority of the time, people think "fast", using time-saving, emotionally-rich rules of thumb (technically called heuristics) that were ideally suited for a hunter gatherer existence 6000 years ago on the Serengeti Plain.
Tim Richards, author of "Investing Psychology: The Effects of Behavioral Finance on Investment Choice and Bias", summarized the negative effects of thinking fast on investors for Monevator.com in 2010,
"We judge people based on stereotypes, we assess the likelihood of events happening based on our ability to retrieve from memory similar events [and] we tend to make decisions based on some arbitrary starting point. Labeled in turn the representative heuristic, the availability bias and anchoring, these three behaviours do a pretty good job of derailing our attempts to rationalise about investments."
For investors, thinking fast is bad. Things we've all done – making buy or sell decisions based on what we paid for a stock (anchoring), or selling because of "what happened last time" (availability bias) – are good examples of investor tendencies that do not work out well in the long term.
Warren Buffett's Not-Stupid investment strategy is a good example of thinking slow. In Kahneman's framework, thinking slow involved conscious repression of emotions and heuristics to access what he calls the brain's System 2, "the only one that can follow rules, compare objects on several attributes, and make deliberate choices between options."
Mr. Buffett's belief in "buying while others are fearful" is a good example of his ability to suppress the habitual "fear" response towards falling stock prices. The Berkshire Hathaway investment emphasis on rules – valuation discipline, and the requirements of stable long term cash flow generation and sustainable competitive advantages – strongly implies the heavy, successful implementation of Kahneman's slow-thinking, deliberate System 2.
Daniel Kahneman is the godfather of Behavioural Economics, a branch of study that has become so rich that summarizing the important implications for investors is difficult. I hope to dig into Behavioural Economics for investors through the summer but for now, the two primary takeaways for investors are 1) Use rules-based investing criteria and 2) Don't let emotions get in the way of following rule one in a consistent, disciplined way.
Above all, think slow.
Scott Barlow