Thinking, Fast And Slow

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By Rudi Filapek-Vandyck, Editor FNArena

Early January I was traveling from Boston to New York, but I missed my train by three minutes. I had to buy a new ticket and wait one full hour for the next train to Pennsylvania Station, NYC. Looking around for a cuppa and a bite, as soon as I passed the small book store in the centre of the grand lobby my attention was drawn to "Thinking, Fast and Slow" by Nobel prize winner Daniel Kahneman. "This is a landmark book… in the same league as Adam Smith's The Wealth of Nations and Sigmund Freud's The Interpretation of Dreams" it read on the backside cover wrap. I bought and started reading.

"Thinking, Fast and Slow" has received many more accolades since its publication in 2011. Earlier this year it was amongst the most popular books on Amazon in the US. Despite not being a typical finance or investment guide, Kahneman's insights into the inner workings of the human brain have already been quoted and referred to in investment research reports. Last week I attended an investment conference in Sydney when one of the delegates, over a ham and cheese sandwich, confided to me: there's this book everyone's been raving about, it's called Thinking, Fast and Slow".

I know, I responded, I read it and it really is very good.

Daniel Kahneman pretty much spent his whole career in trying to figure out how we, rational humans, motivate our actions and come to make decisions. It rewarded him and close friend Amos Tversky with the Nobel Prize in Economic Sciences in 2002. But Kahneman is not your typical economist. His background is psychology which allowed him, and friends like Amos, to tackle the many misconceptions in the world of economics from the left field angle of the non-rational participants in the plethora of daily processes that make up the global economy.

Judging by the many anecdotes in last year's tour de force of nearly five hundred pages, Kahneman has had the type of career many others would sacrifice their left hand for, if only they could enjoy the same results and job satisfaction. Since he decided to put it all together in one standard guide aimed at a broader, non-academic audience, Kahneman's contribution to society's insights and knowledge about what defines human (ir)rationality and the engine behind it all, the human brain, are likely to gain wider acknowledgment in years to come. It is not uncommon for books in finance and economics to be welcomed with lots of hyperbole when reviewed by peers and colleagues, but this one, believe me, deserves it all – in spades.

Thinking, Fast and Slow is going to change the world, if it hasn't already. It is no coincidence, neither an exaggeration by Nassim Nicholas Taleb, author of The Black Swan, to draw a direct comparison with Adam Smith and Sigmund Freud's thought-changing achievements. It is no coincidence either that Kahneman's conclusions and experiments have already started to find their way into investment research reports. After all, isn't one of the major drivers behind developments on financial markets the psychology of market participants?

For investors who have neither time nor inclination to purchase and read Kahneman's masterpiece on the (flawed) human brain, I have chosen three of the core conclusions from the book that I believe are easily applicable on financial markets. I hope that understanding these will pave the way to better investment strategies in the future.

1. Conclusion number one: humans seek correlations, even where there are none. The latter won't stop us from finding them, regardless.

It would be easy for me to conclude that, on said afternoon in early January, some intangible force in the universe made me miss that train to NYC with the ultimate goal so that I would find, purchase and read Thinking, Fast and Slow. As I wrote the previous sentence I could just feel Kahneman cringing in his Princeton University's office.

It is Kahneman's long standing observation, backed up by a career of tests and experiments, that we humans are very good in remembering what we want to remember, while casually forgetting what doesn't suit us. So anyone who thinks he or she has that special ability to know in advance who's calling when the telephone rings, Kahneman has one sobering counter-argument: you are just as likely to guess it right as you are in guessing it wrong, in the long run, it's just that you are more likely to remember the first occasions while forgetting/dismissing the times when you had it wrong.

This is further strengthened by the fact our thought processes can only grasp what we know. For example, I know I missed the train and that, within minutes, I discovered his book. What I don't know is whether I would have bought his book in New York if I hadn't missed the train in Boston. Or in Sydney, for that matter.

In the share market, I am certain Kahneman would be proud of my earlier dismissals of the so-called January effect. First up, it is a given that only about one in four years, on average, fails to generate a positive result for equities. Throw in the knowledge that in most instances investors start the new year with renewed hope and optimism and it is but logical that most Januaries are positive for equities too. But… to then draw the conclusion there's some kind of a predictive power in January's positive opening for the year?

In a similar vein, ever since modern investors discovered technical analysis and price charts it has become popular practice to send around price charts via email that compare, let's say, the meltdown of Nasdaq in 2000 or the Dow Jones in 1929 with the collapse in equities from late 2007 onwards. The underlying suggestion more often than not is: this is how it is going to unfold further. As if there is some kind of a universal blue print about how share market bubbles burst and deflate.

Just so we are clear on this matter: history does provide us with lots of clues and often it does repeat, if only because we never learn from it, but the past seldom provides us with an exact blue print we can never steer away from. Coincidentally, those doom-emails with historic charts always stop going around from the moment modern price action breaks out of the suggested mould.

Also, the human brain is intrinsically lazy while the human psyche feels most comfortable when it is part of a larger group. In financial markets this easily explains the widely accepted herd mentality. This also explains as to why so many myths around markets and investing enjoy long shelf lives as it is far easier for any journalist or commentator to simply repeat what other "experts" already said instead of actually putting that "knowledge" to the test.

Consider the following: in the same week as my own research showed share prices of BHP Billiton ((BHP)), Rio Tinto ((RIO)), Woodside Petroleum ((WPL)) and Santos ((STO)) have barely moved since mid-2009 (almost three years ago) one national newspaper on the Australian east coast opened a feature story on the share market with the observation that mining and energy stocks have served investors well in years past, but will it continue?

Collectively as well as individually, we see what we want to believe and we dismiss what doesn't comply. We feel comfortable in repeating what we've heard before. As an investigative investor (as you should be), have an open mind when doing your own research, but by all means, don't rely on popular media and commentators to show you the way instead of doing your own, unbiased and in-depth research. (I'll promise I will continue doing the same from my chair).

Kahneman does, on occasion, throw in a few real-life anecdotes of his personal experiences with the financial sector, such as his meetings with an experienced funds manager who was just about to make the biggest mistake in his investment career. Trying to figure out whether The Ford Motor Company was a good long term investment or not, this funds manager decided the answer was yes and he went on the company's register in a big way, just before the US automobile industry went bankrupt and had to be bailed out by the Obama administration.

Question: what caused this experienced funds manager to err so badly? Kahneman explains: the funds manager asked himself a question his brain couldn't possibly answer as there were, at that time, too many moving factors. But since the question was asked the brain felt compelled to come up with an answer, so it "secretly" (subconsciously, if you like) changed the question to one it knew it could answer: do I like driving a Ford?

The important message here is clear: 2. be aware of your brain's biases. Because you like a certain product, this doesn't make the company behind the product a compelling investment opportunity. Feel proud of your country and its achievements, but also know that harbouring the world's largest and most diversified resources company does not automatically make BHP Billiton a must Buy at all times and under all circumstances.

Don't fall in love with the stocks you already own either.

3. Pay attention to the principle of mean reversion

There's one stand-out observation in Kahneman's dissection of the human brain that is worth repeating, over and over again: too many of his peers and colleagues waste their time in conducting scientific studies and formulating flawed conclusions that can otherwise be easily explained by mathematicians through the principle of reversion to the mean.

Kahneman provides a very strong example from his work with the Israeli army. During military exercises, officers would shout at cadets performing poorly and applaud the ones that did well, only to find that the second group's performance would subsequently deteriorate while the first group would improve. Conclusion: using the stick works, handing out carrots merely breeds complacency and leads to deteriorating performances. If anything, a very straightforward and logical conclusion. That doesn't mean it is correct.

As Kahneman successfully proved to the military, both the worst and best performances were merely outliers thus given enough repeating exercises it was always going to happen that those extremes to the negative would improve while the outliers on the positive side would be followed by less outstanding performances.

When it comes to financial assets, mean reversion is often on the radar of investors. Often for all the wrong reasons. This is why so many have lost money in recent times when the price differential between Brent crude oil futures and West Texas Intermediate blew out to never seen proportions. Many in the market believed this created an obvious and easy way to make money: position for this price differential to disappear. Similarly, the number of investors having pumped money in Australian retail stocks, or in steel companies, after relative valuations fell to historical lows has been, anecdotally, gi-gan-tic.

Rule number one when playing this theme in financial markets: ask yourself one big question: is there a fundamental change behind the relative change in price? If so, don't assume things will revert back to what used to be the norm because you will lose a lot of money.

On the other hand, it can easily be established that when valuations for equities overshoot to the downside, there will be a normalisation of some sorts at some point, even if, as it is my personal view, there has been a fundamental change and the long term mean can no longer be relied upon. This is, after all, how a new "mean" comes into existence. This is why, by late 2011, the odds had turned in favour of an upswing for equities and this is exactly what has transpired since.

Similar questions can be raised now that profit margins in the US have reached all-time highs, suggesting a peak in the current cycle, while margins in Australia are at multi-decade lows, suggesting the way forward will see margin improvement.

As far as individual stocks are concerned, the fact that Woolworths' ((WOW)) Price-Earnings ratio rose above 27 in late 2007 should have caused all available alarm bells ringing, as should have the fact that margins for QBE Insurance ((QBE)) at that time had expanded to well outside the norm. One question that will increasingly land on investors' radar this year is whether the mean reversion that has since dogged both companies will finally reverse direction for the better?

Thinking, Fast and Slow has been an absolute delight to read. It is compelling, enthralling, revealing, intriguing and inspiring – at times all at the same time. For me personally, reading this book means I now have academic support for many of the non-consensus market observations and analyses I published in years past. Don't be surprised to find more references to Kahneman in the future. If my suspicion proves correct, I won't be the only one doing it.

Thinking, Fast and Slow, by Daniel Kahneman, Eugene Higgins Professor of Psychology Emeritus at Princeton University and Professor of Psychology and Public Affairs Emeritus at Princeton's Woodrow Wilson School of Public and International Affairs, was published by Farrar, Straus and Giroux, New York.

(This story was originally written on Monday, 19th March 2012. It was sent to paying subscribers on that day in the form of an email).

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