Daniel Kahneman has developed a beautiful simple framework for how people think. We use one of two systems based on speed of processing for making decisions. Looking at this framework can answer a number of questions with how to make better investment decisions and how some managers approach behavioral bias and deal with uncertainty.
System 1 is our fast thinking process which is often done unconsciously. It is our quick think process for many easy and routine tasks. It may be more emotion driven and is based on looking for quick links or assessments. This system may jump to quick conclusions, but those may be necessary when we are placed in situations that require a quick response. It is extremely useful for some tasks but also creates problems when undertaking some difficult decisions.
System 2 is our conscious process which is slow, logical, and deliberate. This type of thinking is not useful for simple tasks, but extremely necessary for many of the deeper more complex problem we may face. It is our logical decision center. It is the system we would use for abstract thought. This is not the system of thinking you would use if you have to make a quick decision. It is deliberate and takes time.
Good decision-making understands when to use system 1 or system 2. The mixing of systems is the basis for many decision mistakes.
While the Kahneman framework of fast and slow thinking is now employed by many, it has not been used to describe how and why investors would choose an approach for investment management. For example, can the tension between system 1 and system 2 be used to describe why systematic trading models are used by some managers, or how discretionary decisions are made.
We think the dichotomy between fast and slow can explain why systematic trading is employed by many managers who are active traders. We can walk through the type of traders that will use system 1 and system 2 thinking.
Long-term buy and hold managers who are value traders are likely to be deliberate and careful system 2 thinkers. They are unlikely to be fast reactive traders. Given the thought process of finding good stocks takes time, good discretionary traders will often avoid quick reaction, system 1 thinking. That does not mean that all discretionary traders should avoid active trading, but slow thinking is more consistent with long-term investments and not fast trading. Warren Buffet is an example of a classic system 2 thinker and we know that he will be buying stocks for the long-run.
Active traders have to make quick decisions. They use their gut and instincts for trading and would be classic system 1 thinkers. They will also agree that they could be negatively affected by their emotions. Given they are subject to fast decisions that are prone to mistakes, they have to somehow use their system 2 thinking to help avoid problems.
The mixing of system 1 and system 2 thinking is the foundation for systematic modeling. The modeler can use deliberate slow system 2 thinking to develop and test models. This can be done in a methodical manner which is consistent with system 2. The implementation of the model can then be employed quickly through system 1 thinking and quick reactions. The fast rules are developed through system 2 thinking which then employ a rapid response when signals are generated. Systematic trading offsets the problems associated with system 1 thinking through careful slow thought in the back-testing laboratory.
We think the dichotomy between fast and slow can explain why systematic trading is employed by many managers who are active traders. We can walk through the type of traders that will use system 1 and system 2 thinking.
Long-term buy and hold managers who are value traders are likely to be deliberate and careful system 2 thinkers. They are unlikely to be fast reactive traders. Given the thought process of finding good stocks takes time, good discretionary traders will often avoid quick reaction, system 1 thinking. That does not mean that all discretionary traders should avoid active trading, but slow thinking is more consistent with long-term investments and not fast trading. Warren Buffet is an example of a classic system 2 thinker and we know that he will be buying stocks for the long-run.
Active traders have to make quick decisions. They use their gut and instincts for trading and would be classic system 1 thinkers. They will also agree that they could be negatively affected by their emotions. Given they are subject to fast decisions that are prone to mistakes, they have to somehow use their system 2 thinking to help avoid problems.
The mixing of system 1 and system 2 thinking is the foundation for systematic modeling. The modeler can use deliberate slow system 2 thinking to develop and test models. This can be done in a methodical manner which is consistent with system 2. The implementation of the model can then be employed quickly through system 1 thinking and quick reactions. The fast rules are developed through system 2 thinking which then employ a rapid response when signals are generated. Systematic trading offsets the problems associated with system 1 thinking through careful slow thought in the back-testing laboratory.
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