Our minds are intricate machines capable of both rapid, intuitive reactions and slow, deliberate reasoning. The dual-process theory of cognition, popularized by Nobel laureate Daniel Kahneman in his book “Thinking, Fast and Slow”, divides our thinking into two systems: System 1 and System 2.
As investors we must take stock over time and use our system 2 to make further decisions.
Do I refinance and unlock equity for more purchases?
Do I sell down if the market conditions are changing?
Do I invest in commercial instead of residential?
These are all system 2 questions. So why do we have system 1?
System 1: Fast, Automatic, and Intuitive
System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control. It encompasses the brain’s fast, intuitive, and emotional responses. Here are some key characteristics:
- Automatic: System 1 thinking happens subconsciously and effortlessly. This is the system responsible for instant reactions, like pulling your hand back from a hot stove.
- Rapid: Because it’s based on instinct and past experiences, System 1 processes information almost instantaneously.
- Pattern Recognition: System 1 is adept at recognizing patterns and making quick judgments. For example, when driving on a familiar route, you rely on System 1 to navigate without much conscious thought.
- Emotional: System 1 is closely linked with emotions. Gut feelings and first impressions are prime examples of System 1 at work.
System 2: Slow, Deliberate, and Analytical
System 2 involves conscious, deliberate thought processes that require effort and attention. It’s slower and more methodical, and it engages in reasoning and problem-solving. Here are some key characteristics:
- Deliberate: System 2 thinking requires conscious effort and attention. When you’re solving a complex math problem or making a big decision, System 2 is in control.
- Analytical: System 2 engages in logical reasoning and analysis. It’s responsible for evaluating options, considering potential outcomes, and making calculated decisions.
- Slow: Unlike the rapid responses of System 1, System 2 processes information more slowly, allowing for thorough examination and reflection.
- Controlled: System 2 operates with a sense of voluntary control. You can consciously engage System 2 to override the intuitive responses of System 1.
As investors we must spend the majority of the time when looking at our portfolio using system 2. There is very little advantage to be gained using our system one or “gut feel process”, this is when we make emotional decisions that cost money.
Interaction Between System 1 and System 2
While System 1 and System 2 serve different functions, they often work together to shape our decision-making. Here’s how they interact:
- Conflict and Override: System 2 can override the impulses of System 1 when necessary. For instance, if you have an intuitive desire to make a hasty purchase, System 2 can step in to analyze whether it’s a wise financial decision.
- Cognitive Ease: In situations where System 1 processes align with System 2’s analysis, decision-making feels smooth and effortless. This cognitive ease occurs when there is consistency between quick intuition and careful reasoning.
- Cognitive Strain: When System 1 and System 2 are in conflict, it creates cognitive strain. For example, when a complex problem requires slow, deliberate thought, but intuitive responses urge you to act quickly, you experience mental tension.
To make better decisions around your investments you need to understand this!
Understanding the dynamics between System 1 and System 2 can significantly impact various aspects of life:
- Decision-Making: Recognizing when to rely on intuitive judgments and when to engage in deliberate analysis can lead to more balanced and effective decisions.
- Problem-Solving: Complex problems benefit from System 2’s analytical approach, while familiar, routine tasks can be efficiently managed by System 1.
- Personal Growth: Awareness of these cognitive processes can help individuals identify and mitigate biases, improving critical thinking and emotional regulation.
Conclusion
The dual-process theory of cognition provides valuable insights into how we think and make decisions. By understanding the roles and interactions of System 1 and System 2, individuals can better navigate the complexities of life, balancing intuitive responses with thoughtful analysis for more informed and rational outcomes.
To ensure the ongoing success of your investment portfolio you need to undertake a proper review of where you are at and what you can do next.
The best way to do this is be objective, look at the numbers and avoid “Gut feel” or System 1 thinking.
