Thinking Fast & Slow. Cognitive biases that trick us. How Loss Aversion harm your long-term returns?

Loss Aversion

This is one of the most powerful concepts in behavioral economics. "It hurts more to lose $X than it feels good to gain $X." This leads to irrational behaviors, such as:

• Holding onto losing stocks for too long (hoping to "break even" to avoid realizing the loss).

• Selling winning stocks too early (to "lock in" the gain and avoid the risk of losing it).

Daniel Kahneman's Thinking, Fast and Slow

The core idea of the book is that our thinking is governed by two systems:

• System 1: Fast, automatic, intuitive, and emotional.

• System 2: Slow, deliberate, analytical, and effortful.

The text highlights how System 1, while efficient, is prone to systematic errors (biases) that significantly impact our judgment, especially in complex areas like investing.

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Summary of the Main Points

The notes outline several key cognitive biases from System 1 that lead to flawed decision-making:

1. Cognitive Ease: We prefer information that is easy to process, which can make us accept familiar or simple statements without critical analysis.

2. Priming Effect: Our thoughts and behaviors can be subtly influenced by unrelated stimuli we've been exposed to previously.

3. Anchoring Effect: We rely too heavily on the first piece of information we receive (the "anchor") when making decisions.

4. Hindsight Bias: After an event has occurred, we tend to believe we "knew it all along," oversimplifying the causes and underestimating the uncertainty that existed beforehand.

5. Loss Aversion: The pain of losing is psychologically about twice as powerful as the pleasure of gaining an equivalent amount. We strongly prefer avoiding losses to acquiring gains.

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Expanded Discussion and Explanation

Here is a clearer breakdown of each concept, explaining how they "trick" us.

1. The Two Systems: The Foundation

• System 1 (Fast Thinking): This is your gut reaction. It operates automatically and quickly, with little or no effort. It's responsible for reading emotions on someone's face, driving a car on an empty road, or knowing that 2 + 2 = 4. While essential for daily life, it often jumps to conclusions based on patterns and shortcuts (heuristics).

• System 2 (Slow Thinking): This is your deliberate, analytical mind. It's mobilized for complex tasks that require focus, like solving a difficult math problem, filling out a tax form, or comparing two products in detail. It's lazy and often defers to System 1 unless specifically engaged.

The Trick: Because System 2 is effortful, we often rely on the quicker, but error-prone, System 1 for decisions that would benefit from more careful thought.

2. Why System 1 Tricks Us: Key Biases

A. Cognitive Ease
This is a state where your brain is on cruise control. When something feels familiar, simple, or easy to process, System 1 gives it a "stamp of approval." This makes you more likely to believe a statement simply because it's repeated, well-presented, or rhymes. The text's line, "You can’t detect a statement of the time," hints at this—we often accept information without verifying it when we're in a state of cognitive ease.

B. Priming Effect
Your recent experiences unconsciously influence your current thoughts and actions. The example given is excellent: if a store plays French music, you might be primed to buy French wine. You're not consciously aware of the influence, but System 1 is guided by these subtle cues.

C. Anchoring Effect
When making estimates or decisions, we give disproportionate weight to the first number we hear. The investing example is clear: if you receive an initial price target for a stock (STSB), that number becomes an "anchor." All subsequent analysis and price judgments are made in relation to that anchor ("your recommendation follows this set to get a new form code after that will be compared to STSB"). This can skew your valuation significantly.

D. Hindsight Bias (The "I-knew-it-all-along" Effect)
This bias rewrites our memory. After an event (like a stock market crash or a successful product launch), it seems to have been inevitable. The text captures this perfectly: "Looking back at it, it looked like the only problem where... But it wasn’t." This is dangerous because it prevents us from learning from past mistakes. If we think we knew what was going to happen, we don't analyze the actual, uncertain factors that were present at the time.

E. Loss Aversion
This is one of the most powerful concepts in behavioral economics. "It hurts more to lose $X than it feels good to gain $X." This leads to irrational behaviors, such as:

• Holding onto losing stocks for too long (hoping to "break even" to avoid realizing the loss).

• Selling winning stocks too early (to "lock in" the gain and avoid the risk of losing it).

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How It Affects Our Investing (Synthesis)

The application to investing is direct and critical:

• Anchoring Effect can cause you to hold onto a stock because you're anchored to the price you bought it at, ignoring new, negative information.

• Hindsight Bias can make you overconfident. If you believe you predicted the last market move, you'll be less cautious about the next one, which is inherently unpredictable.

• Loss Aversion is the enemy of a disciplined investment strategy. It causes you to make emotionally-driven decisions—panic selling in a downturn or being too conservative to enter the market—that harm long-term returns.

• Cognitive Ease might lead you to invest in a well-known, popular company without doing your own deep research (System 2 analysis) simply because the name is familiar.

Conclusion

The notes from Thinking, Fast and Slow serve as a crucial warning: our intuitive mind, while a powerful tool, is riddled with biases that are particularly detrimental in the high-stakes, uncertain world of investing. To become a better decision-maker and investor, you must learn to recognize these biases and consciously engage your slow, analytical System 2 to question your initial instincts, analyze data objectively, and make more rational choices.

Thinking, Fast and Slow (Daniel Kahneman)

Thinking, Fast and Slow is a 2011 book by Nobel Memorial Prize winner in Economics Daniel Kahneman which summarizes research that he conducted over decades, often in collaboration with Amos Tversky. It covers all three phases of his career:
- his early days working on cognitive bias,
- his work on prospect theory, and
- his later work on happiness.

The book's central thesis is a dichotomy between two modes of thought :
- System 1 is fast, instinctive and emotional;
- System 2 is slower, more deliberative, and more logical.
The book delineates cognitive biases associated with each type of thinking, starting with Kahneman's own research on loss aversion. From framing choices to substitution, the book highlights several decades of academic research to suggest that people place too much confidence in human judgment.


Contents
1 Prospect theory
2 Two systems
3 Heuristics and biases
3.1 Anchoring
3.2 Availability
3.3 Substitution
3.4 Optimism and loss aversion
3.5 Framing
3.6 Sunk-cost
4 Choices
5 Rationality and happiness
5.1 Two selves


The basis for his Nobel prize, Kahneman developed prospect theory to account for experimental errors he noticed in Daniel Bernoulli's traditional utility theory. This theory makes logical assumptions of economic rationality that do not reflect people’s actual choices, and does not take into account behavioral biases.

One example is that people are loss-averse: they are more likely to act to avert a loss than to achieve a gain. Another example is that the value people place on a change in probability (e.g. of winning something) depends on the reference point: people appear to place greater value on a change from 90% to 100% (going from high probability to certainty) than from, say, 45% to 55%, and place the greatest value of all on a change from 0% to 10% (going to a chance of winning from no chance). This despite that all three changes give the same increase in utility. Consistent with loss-aversity, the order of the first and third of those is reversed when the event is presented as losing rather than winning something: there, the greatest value is placed on eliminating the probability of a loss to 0.

Two systems

In the book's first section, Kahneman describes the two different ways the brain forms thoughts:
System 1: Fast, automatic, frequent, emotional, stereotypic, subconscious
System 2: Slow, effortful, infrequent, logical, calculating, conscious

Kahneman covers a number of experiments which purport to highlight the differences between these two thought processes, and how they arrive at different results even given the same inputs. Terms and concepts include coherence, attention, laziness, association, jumping to conclusions and how one forms judgments.

Heuristics and biases

The second section offers explanations for why humans struggle to think statistically. It begins by documenting a variety of situations in which we either arrive at binary decisions or fail to precisely associate reasonable probabilities to outcomes. Kahneman explains this phenomenon using the theory of heuristics.

Kahneman uses heuristics to assert that System 1 thinking involves associating new information with existing patterns, or thoughts, rather than creating new patterns for each new experience. For example, a child who has only seen shapes with straight edges would experience an octagon rather than a triangle when first viewing a circle. In a legal metaphor, a judge limited to heuristic thinking would only be able to think of similar historical cases when presented with a new dispute, rather than seeing the unique aspects of that case. In addition to offering an explanation for the statistical problem, the theory also offers an explanation for human biases.

Anchoring

The “anchoring effect” names our tendency to be influenced by irrelevant numbers. Shown higher/lower numbers, experimental subjects gave higher/lower responses. Experiment: experienced German judges proposed longer sentences if they had just rolled a pair of dice loaded to give a high number.

Availability

The availability heuristic is a mental shortcut that occurs when people make judgments about the probability of events by how easy it is to think of examples. The availability heuristic operates on the notion that, "if you can think of it, it must be important." The availability of consequences associated with an action is positively related to perceptions of the magnitude of the consequences of that action. In other words, the easier it is to recall the consequences of something, the greater we perceive these consequences to be. Sometimes, this heuristic is beneficial, but the frequencies that events come to mind are usually not accurate reflections of the probabilities of such events in real life.

Substitution

System 1 is prone to substituting a simple question for a more difficult one. In what Kahneman calls their “best-known and most controversial” experiment, “the Linda problem.” Subjects were told about an imaginary Linda, young, single, outspoken and very bright, who, as a student, was deeply concerned with discrimination and social justice. They asked whether it was more probable that Linda is a bank teller or that she is a bank teller and an active feminist. The overwhelming response was that “feminist bank teller” was more likely than “bank teller,” violating the laws of probability. (Every feminist bank teller is a bank teller.) In this case System 1 substituted the easier question, "Is Linda a feminist?" dropping the occupation qualifier. An alternative view is that the subjects added an unstated implicature to the effect that the other answer implied that Linda was not a feminist.

Optimism and loss aversion

Kahneman writes of a "pervasive optimistic bias", which “may well be the most significant of the cognitive biases.” This bias generates the illusion of control, that we have substantial control of our lives. This bias may be usefully adaptive. Optimists are more psychologically resilient, have stronger immune systems, and live longer on average than more reality-based opposites. Optimism protects from loss aversion: people's tendency to fear losses more than we value gains.

A natural experiment reveals the prevalence of one kind of unwarranted optimism. The planning fallacy is the tendency to overestimate benefits and underestimate costs, impelling people to take on risky projects. In 2002, American kitchen remodeling was expected on average to cost $18,658, but actually cost $38,769.

To explain overconfidence, Kahneman introduces the concept he labels What You See Is All There Is (WYSIATI). This theory states that when the mind makes decisions, it deals primarily with Known Knowns, phenomena it has already observed. It rarely considers Known Unknowns, phenomena that it knows to be relevant but about which it has no information. Finally it appears oblivious to the possibility of Unknown Unknowns, unknown phenomena of unknown relevance.

He explains that humans fail to take into account complexity and that their understanding of the world consists of a small and not necessarily representative set of observations. Furthermore, the mind generally does not account for the role of chance and therefore falsely assumes that a future event will mirror a past event.

Framing


Framing is the context in which choices are presented. Experiment: subjects were asked whether they would opt for surgery if the “survival” rate is 90 percent, while others were told that the mortality rate is 10 percent. The first framing increased acceptance, even though the situation was no different.

Sunk-cost

Rather than consider the odds that an incremental investment would produce a positive return, people tend to "throw good money after bad" and continue investing in projects with poor prospects that have already consumed significant resources. In part this is to avoid feelings of regret.

Choices

In this section Kahneman returns to economics and expands his seminal work on Prospect Theory. He discusses the tendency for problems to be addressed in isolation and how, when other reference points are considered, the choice of that reference point (called a frame) has a disproportionate impact on the outcome. This section also offers advice on how some of the shortcomings of System 1 thinking can be avoided.

Rationality and happiness

Evolution teaches that traits persist and develop because they increase fitness. One possible hypothesis is that our conceptual biases are adaptive, as are our rational faculties. Kahneman offers happiness as one quality that our thinking process nurtures. Kahneman first took up this question in the 1990s. At the time most happiness research relied on polls about life satisfaction.

Two selves

Kahneman proposed an alternate measure that assessed pleasure or pain sampled from moment to moment, and then summed over time. Kahneman called this “experienced” well-being and attached it to a separate "self". He distinguished this from the “remembered” well-being that the polls had attempted to measure. He found that these two measures of happiness diverged. His major discovery was that the remembering self does not care about the duration of a pleasant or unpleasant experience. Rather, it retrospectively rates an experience by the peak (or valley) of the experience, and by the way it ends. Further, the remembering self dominated the patient's ultimate conclusion.

Kahneman demonstrated the principle using two groups of patients undergoing painful colonoscopies. Group A got the normal procedure. Group B, unknowingly received a few extra minutes of less painful discomfort after the end of the examination, i.e., more total discomfort. However, since Group B’s procedure ended less painfully, the patients in this group retrospectively minded the whole affair less.

“Odd as it may seem,” Kahneman writes, “I am my remembering self, and the experiencing self, who does my living, is like a stranger to me.”


http://en.wikipedia.org/wiki/Thinking,_Fast_and_Slow

Why even experts must rely on intuition and often get it wrong

There have been many good books on human rationality and irrationality, but only one masterpiece. That masterpiece is Daniel Kahneman’s Thinking, Fast and Slow.

Kahneman, a winner of the Nobel Prize for economics, distils a lifetime of research into an encyclopedic coverage of both the surprising miracles and the equally surprising mistakes of our conscious and unconscious thinking. He achieves an even greater miracle by weaving his insights into an engaging narrative that is compulsively readable from beginning to end. 

Thinking, Fast and Slow, by Daniel Kahneman

Kahneman presents our thinking process as consisting of two systems. System 1 (Thinking Fast) is unconscious, intuitive and effort-free. System 2 (Thinking Slow) is conscious, uses deductive reasoning and is an awful lot of work. System 2 likes to think it is in charge but it’s really the irrepressible System 1 that runs the show. There is simply too much going on in our lives for System 2 to analyse everything. System 2 has to pick its moments with care; it is “lazy” out of necessity.

Books on this subject tend to emphasise the failings of System 1 intuition, creating an impression of vast human irrationality. Kahneman dislikes the word “irrationality” and one of the signal strengths of Thinking, Fast and Slow is to combine the positive and negative views of intuition into one coherent story. In Kahneman’s words, System 1 is “indeed the origin of much that we do wrong” but it is critical to understand that “it is also the origin of most of what we do right – which is most of what we do”.

http://www.ft.com/cms/s/2/15bb6522-04ac-11e1-91d9-00144feabdc0.html#axzz2jwvK7LJC