In 2002, Dr. Daniel Kahneman won the Nobel Prize in Economics for his research into the role cognitive biases play in decision-making during times of uncertainty. Specifically, he observed that we tend to have pre-conceived notions on just about everything, and those notions can influence almost everything we do.
According to Dr. Kahneman, our brains come hard-wired with two systems. The first is the system we use almost effortlessly to make quick judgments, such as reacting to a threat or reading the expression on someone's face. The second is our "thinking system," which, for example, kicks in when we have to do our taxes or multiply 27 times 38.
As a species, we tend not to like using System #2. Deep thinking causes us to burn glucose, dilate our pupils and increase our breathing. It's much easier and quicker to use System #1. Unfortunately, relying on quick, easy conclusions can also get us into a whole lot of trouble.
Take the following example from Kahneman's latest book, "Thinking, Fast and Slow" (named by Amazon.com as one of the Best Books of 2011). Let's say you're introduced to someone who is single, bookish, quiet, and who prefers their own company to the company of others. Would you tend to think this person is more likely to be a librarian, or a farmer?
Based on this description, most people immediately lean towards librarian. Yet in reality, there are almost 20 times as many farmers as there are librarians, so it's actually statistically much more likely that the person we're meeting is a farmer.
Of course, this isn't to say that System #1 thinking is all bad. Our "think fast" system works quite well at a lot of things. For example, you don't want to pause to analyze the physics of jumping when a speeding car is barreling down on you. Similarly, there's no need to stop to calculate whether or not to hug your child when you see them in tears.
But our tendency to rely on the quick-and-easy System #1 for everything can often get in the way, particularly in areas where you may only occasionally need to focus your full attention. One of the best examples of these is your investments.
We all like to think we make sensible choices when it comes to our investments, and that we use our objective capacity to ensure our money goes to the right places. Too often, however, we let our feelings guide even our most basic and fundamental investment decisions, such as where to put our money or what to sell and buy.
I had a conversation recently with someone who's in the process of selling his stock portfolio in order to go out and buy a condominium as an investment. After all, real estate, as we all know, has been on a tear for the last 10 years, and he wanted to get in while the getting was still good.
In other words, he was making this major life decision using only his System #1 thinking, which told him that real estate is always the best investment, without testing his assumption to see whether or not it was actually true. But what happens if we slow down for a second, and bring our System #2 "deep thinking" skills into play?
Consider the facts. The price for this particular condo was $500 a square foot. At this price, the rent he would be able to charge comes nowhere near covering the cost of his mortgage, let alone all the other expenses involved. In addition, renting out the condo would mean taking on the burden of tenants, and adding to his already-busy workload.
On the other side of the equation, the stocks he wants to sell currently have a dividend yield of about 3%. Stocks these days are trading around eight times cash flow, and are arguably at a very low point in the market cycle. They take no time or effort to own, and if history is any guide, they will return three to four times their capital over the next 20 years.
Now, I have nothing against real estate. I own some myself, and we've advocated incorporating real estate into some of our clients' portfolios. The difficulty I see in this case isn't that this person decided to buy a condo. It's that, when asked what his reasons were for making the switch, all he could say was he's "just more comfortable in real estate," and "it's real estate, so it will always go up."
Doing something for no reason other than because it makes us feel "comfortable" is classic System #1 thinking. It's what allows us to confidently make important decisions that completely ignore, or even outright reject, the actual facts.
If we take a look at the broad historical experience of the North American real estate market, we can definitely say that real estate doesn't always go up. Just ask someone who bought a condo in Las Vegas or Miami five or six years ago.
But this person's System #1 thinking told him that real estate is a can't-lose investment. As a result, he felt comfortable making this choice, without taking the time to find out whether or not it was really the right choice for him.
The problem with his decision to sell the stocks isn't about either the stocks or the real estate. The problem is that it's a big financial decision, which should be made with careful, slow and detailed System #2 thinking.
System #1 works great for some things. Investments just aren't one of them.
Alan MacDonald an Investment Advisor with Richardson GMP Limited, helps investors with over $500,000 of assets make smart decisions about money. Alan is the co-author of "The Copperjar System, Your Blueprint for Financial Fitness" available on Amazon.
For more information please visit www.alanmacdonald.ca or email Alan at Alan.Macdonald@RichardsonGMP.com.
All material by Alan MacDonald, Investment Advisor at Richardson GMP Limited. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.
Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.
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