“What’s 2 + 2?”
You can’t help but think of the answer instantly. Your mind throws the number “4” on your thought screen. It’s actually impossible to not think of the answer here, unless you haven’t learnt to count to ten.
The answer is almost like a reflex. It was an instance of fast thinking. In fact, you don’t even need to consciously think about it. It just happens to you. This is the result of what scientists call reflexive brain.
Now if I ask you, “What’s 38 multiplied by 27?”
For most of you, except if you’re a math wizard, your brain goes blank. It doesn’t give you any instant answer. You’ll have to take a pause and calculate the answer with some efforts, and if you’re like me you won’t be able to do it without pen and paper. Here you have to involve a part of your brain which is known as the reflective brain. You experience a slow mode of thinking as you proceed through a sequence of steps to solve this multiplication problem.
Reflexive brain is quick and it tends to jump to conclusion. Reflective brain is much slower, requires effort, it’s logical and, as we’ll see later, less prone to error.
Daniel Kahneman, a nobel laureate who is also known as the founding father of modern behavioural economics, in his book Thinking Fast and Slow, has termed these two modes of thinking as System 1 (reflexive) and System 2 (reflective).
System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control.
System 2 allocates attention to the effortful mental activities that demand it, including complex computations. The operations of System 2 are often associated with the subjective experience of agency, choice, and concentration.
In other words, System 1 and System 2 modes of thinking can be imagined as intuitive and deliberate thought respectively.
So these two don’t really exist physically inside your skull. They are mere representation, a mental model if you will, of the way to understand how human brain carries out the task of thinking. Consider these two systems as agents within the mind, with their individual personalities, abilities, and limitations.
“Systems 1 and 2 are both active whenever we are awake.”, says Kahneman, “System 1 runs automatically and System 2 is normally in a comfortable low-effort mode.”
So for most of our routine tasks like walking, talking, reading, driving, etc., System 1 is engaged in helping us make quick and efficient decisions. System 1 is the first layer of thinking that any problem is delegated to by our brains. System 2 comes into picture only when a question arises for which System 1 does not offer an answer, as probably happened to you when you encountered the multiplication problem 38 × 27.
The arrangement works well most of the time because System 1 is generally very good at what it does. But things aren’t as perfect as they seem. Our hero, i.e. System 1 is an overconfident guy. And under many specific conditions, which should ideally be delegated to System 2, our System 1 insists on making a decision and ends up creating systematic errors. These systematic errors from System 1 are called biases.
Here’s a simple example. Look at the image below. There are three sentences inside the triangles. Read them out loudly.
Did you notice the mistake? Don’t feel bad if you didn’t because most people fail to notice the error.
In the first sentence, word “the” appears twice before the word “spring”. Same with the third sentence. And similarly in the second sentence the word “a” repeats.
So what really happened?
Reading is pretty much an effortless activity (as far as understanding the literal meaning of the sentence is concerned) which is done by System 1. So in a hurry to make sense of the things, System 1 does these optimizations on its own level and hence these small inconsistencies remain invisible to us because of shortcuts taken by System 1.
You may say that it was a case of an optical illusion, so here’s another example which doesn’t involve any images. This is a very simple math problem. Instead of trying to solve it, just observe the first intuitive answer that comes to your mind because that will give you a clue to workings of System 1.
The total cost of Bat and a Ball is 110 rupees.
The cost of Bat is 100 rupees more than the Ball.
How much does the Ball cost?
If you’re in a hurry you would quickly conclude that “the ball costs 10 rupees” which is a wrong answer. If you do the math little slowly (using System 2), you’ll realize that the right answer is – ball costs 5 rupees and the bat costs 105 rupees.
In all such situations you must pay attention, and you will perform less well, or not at all, if you are not ready or if your attention is directed inappropriately. Use of System 2 requires attention and its operation is disrupted when the attention is taken away.
The sloppiness of System 1 is what creates cognitive biases. And that makes System 1 a very interesting subject of study. The whole field of behavioural economics stems out from the need to understand the peculiar characteristics of System 1. So let’s see how did this dude called System 1 come to be.
Origins of System 1
The System 1 thinking or the reflexive brain is a gift from evolution. Our ancestors were hunter gatherers and lived in jungles where there was a constant threat of being eaten by a wild beast. So when they sensed a movement in the bushes it was probably a predator about to jump on them. The only way our ancestors could survive was to run at any such signs.
These reflexes or instincts, to run away from a potential danger, created a strong evolutionary advantage for homo sapiens and resulted in the development of reflexive brain. Imagine if I was in the same situation and upon sensing the movement in the bushes, instead of running, I pulled out my smart phone and started googling – “what does noise from bushes mean?” – by the time google gives me an answer I would be a dead meat.
Now the process of evolution is slow. So those instincts which our ancestors developed are still present in us. Our bodies and minds haven’t changed much in last few thousands years but the environment in which we live in has changed dramatically. The threat of being attacked by a lion isn’t there anymore, unless of course you decide to jump inside the cage of a lion in a zoo.
Many of these instincts aren’t very useful in present day. But they do influence of our decision making. In the modern world these biases cause us to make big mistakes particularly in the financial markets.
When it comes to money and investing, presence of System 1 makes our brains ill-equipped to handle the situations. Investing is an area which presents many situations where reliance on System 1 gets us fooled into making very serious errors of judgment.
Many psychological biases that we have seen in this Latticework series (and many other which we will cover in future) are brainchild of System 1. Some of them are – Anchoring Effect, Overconfidence Bias, Confirmation Bias, Scarcity Bias, Authority Bias, Social Proof, Base Rate Neglect, Liking Bias etc.
Anchoring effect happens when people get hung up on the stock prices instead of the quality of the underlying business. System 1 thinking compares the current price to the recent high-low prices (anchor) and jumps to faulty conclusions.
Confirmation bias is that property of System 1 which makes it prone to remain consistent with its earlier decisions or commitments. System 1 selectively seeks only that information which is consistent to its beliefs and discards any disconfirming evidence.
When we see someone dressed as doctor on the TV, we assume that he knows what he’s talking about. Similarly, when a stock market expert (suit-tie wearing talking heads who like to show off their financial jargon vocabulary) forecasts the market movements and the macroeconomic shifts, System 1 falls for the Authority Bias and believes him.
Liking bias makes us prone to favour those whom we like. It’s very common for people to get duped into buying useless financial products because the so called financial advisor (a salesman) comes across as a likeable person because of his or her pleasant personality and extraordinary communication skills.
Base rate neglect is another such erroneous thinking where System 1 ignores the underlying base rate of success. If someone claims that his grandfather was a chain smoker and lived up to a ripe age of 95, he’s ignoring the statistics. Base rate says that statistically a chain smoker is unlikely to live a long life. Grand father was an exception, an outlier and you can’t make your decisions based on such anecdotal evidences. But Systems 1 tends to fall for such misleading stats.
Everyone knows some friend of a friend who made lot of money in an IPO. But don’t forget that the base rate of making money in IPOs is very poor.
All these biases of System 1 can wreak havoc and cause serious damage to our financial well being. So how do you fight with System 1?
Stubborn System 1
When I first learnt about System 1, I thought to myself, “Well if System 1 is such a troublemaker, and now that I know its various forms, I should be able to avoid it easily.”
Turns out that it’s not that easy.
“System 1 operates automatically and cannot be turned off at will, errors of intuitive thought are often difficult to prevent.”, writes Kahneman, “Biases cannot always be avoided, because System 2 may have no clue to the error.”
But let’s say you learn to reject the first intuitive response in every situation and call upon System 2 to find the more calculated and rational answer. Would that help? According to Kahneman, it would be an overkill. He writes –
As a way to live your life, however, continuous vigilance is not necessarily good, and it is certainly impractical. Constantly questioning our own thinking would be impossibly tedious, and System 2 is much too slow and inefficient to serve as a substitute for System 1 in making routine decisions. The best we can do is a compromise: learn to recognize situations in which mistakes are likely and try harder to avoid significant mistakes when the stakes are high.
Notice the point – when the stakes are high. So when you’re making an investment, it’s a high stake situation. But if you’re buying a toothpaste, you can give System 2 some rest and go with System 1.
System 1 Vs System 2 is a brilliant mental model to explain the machinery of thought. And when it comes to the subject of thinking, Daniel Kahneman’s book is a bible. Let me borrow Shane Parrish’s words to give you a sample of what Kahneman’s book holds –
Kahneman exposes the extraordinary capabilities—and also the faults and biases—of fast thinking, and reveals the pervasive influence of intuitive impressions on our thoughts and behaviour. The impact of loss aversion and overconfidence on corporate strategies, the difficulties of predicting what will make us happy in the future, the challenges of properly framing risks at work and at home, the profound effect of cognitive biases on everything from playing the stock market to planning the next vacation—each of these can be understood only by knowing how the two systems work together to shape our judgments and decisions.
You can’t call yourself a serious student of behavioural economics if you haven’t read Daniel Kahneman’s book.
And if you have read it already, then you would know that it’s a book that needs to be read once every year. So when are you going to read it again? 🙂
Take care and keep learning.