In his book “Thinking, Fast and Slow” Daniel Kahneman describes a theory of humans’ two modes of thinking: System 1 (fast, subconscious, effortless, automatic) and System 2 (slow, conscious, logical, requires effort, responsible for controlling behaviour)
Our tendency is to tackle incoming stimuli with fast and effortless System 1, but result may lead to decisions which are less than optimal. The book explains in terms of fast and slow thinking: “utility theory”, “prospect theory” and “framing effects”, “reference points”, “endowment effects”, “possibility effect” vs. “certainty effect”, “mental accounting”, “sunk cost fallacy”, value of “broader framework” vs. “narrower framework”. He also discusses a lot of these concepts in context of “behavioural finance”.
Some of his interesting observations include: “people engaged in a “mental sprint” can become effectively blind”, “as skill increases, brain activity decreases”, (here is one that we all could have used before) as part of planning a project use a “pre-mortem” which effectively legitimizes doubts and allows a search for threats where knowledgeable members of the project team are asked to “Imagine we are one year in the future. We implemented the plan as is. Outcome was a disaster. Write a brief history of the disaster.”, we have an “illusion of skill” and “errors of prediction are inevitable because the world is unpredictable”, “algorithms are better than humans”. He uses utility theory to explain “why poor people buy insurance while richer people sell it to them”, uses prospect theory to explain the surprise of risk seeking behavior when presented with a “high probability” of a “large loss” (i.e. having to choose between bad options and ending up with an even worse outcome), explanation of how we choose default vs. action because we prefer regret to blame, and that losses are weighed twice as much as gains. (If you are interested in an abbreviated quick read on behavioural finance consider Nofsinger’s book the “Psychology of Investing”, of which I provide a super-abbreviated summary in “Behavioral Finance”.)
Kahneman also makes a pitch for Thaler and Sunstein’s book entitled “Nudge” on how these theories are used “to help people make good decisions without curtailing their freedom” encouraging a system of “libertarian paternalism”. He mentions the very successful approach to getting people to commit to increase their future retirement savings when they enrol into 401(k) plans based on default set at “auto-enrolment” and a “save more tomorrow” commitment.
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