I've been absent for some time, for that I apologize. One of my "New Year Resolutions" was to start reading again. I should have known how that would end. When I was younger I was a voracious reader and would spend all my free time reading, mostly history. That fire has been reignited and old habits have returned with a vengeance.
One of the more impactful books I've read so far this year has been Thinking Fast and Slow by Nobel Laureate Daniel Kahneman. The man has spent his entire life thinking about how people think and, along with the late Amos Tversky, made behavioral economics a mainstream topic that has spawned the like of Richard Thaler, Cass Sunstein, and countless others. The book is the man's life work expertly placed on several hundred pages and is a true gift to the reader.
Professor Kahneman is an Israeli psychologist but broke into economics by challenging the topic, more specifically how people make decisions. He has created for us subjects known as System 1 and System 2. The decisions we make from System 1 are more reactive and instant, laughing at a funny joke, jumping back in horror as someone jumps out to scare us, or batting away a fly. System 2 is the more deliberate decision making instrument for us; whether or not to buy that car, what college you should attend, if you should buy stock in X or Y. Where System 1 allows us to make decision with little to no thought, System 2 requires more investigation and deeper thought.
This is a problem posed in the book. If you would please, quickly get your answer and then keep reading.
A bat and a ball cost $1.10.
The bat costs $1 more than the ball.
How much does the ball cost?
My favorite conclusion from the entire book is that System 1, which I'll call S1 from here on out, often tricks and deceives S2. A problem may be presented to us and we resolve it using S1, reaching what we think is the correct solution and moving on the next problem. Now revisit the problem. How much does the ball cost? If you said $0.10, S1 has claimed another victim like it claimed me. To avoid a lengthy explanation I'll just tell you that the ball costs $0.05. $0.05+$1=$1.05+$0.05=$1.10. When you start to think about this more it is almost horrifying. We do this all day, all the time, and with issues much bigger than some hypothetical bat and ball problem. Corporations market directly to our S1, all but guaranteeing we make some dumb decisions. No company really wants us to activate S2 in deciding if we want to buy something.
The good news is that we really have little choice in this. As a species we have survived because of our S1. We know that the lion on the Great Plains of Africa is dangerous and we should avoid it. S1 allows us to make vital decisions quickly, saving precious time for other decisions. If we stopped and put deep thought into whether or not to run away from a bear we would quickly become bear lunch. The first human to have encountered a charging bear probably engaged S2, thinking deeply about what the bear wanted, those watching this individual get devoured no longer had to engage S2, having shifted this problem directly to S1.
With this revelation in hand, that we can "learn" our S2 into S1 and vice versa, I began thinking about how this impacts all sorts of thinking. I had some good discussions with some of the Marines I work with. My favorite was this:
When you are firing your rifle and you pull the trigger and it doesn't fire, what do you do? If you know any Marine who has ever served with the M16 or M4 go ahead and ask them. The answer will (should) be "Tap, rack, bang." An unfamiliar civilian, or an untrained recruit, would not know this answer. When you pull the trigger and hear a click and not a boom we are all trained to tap the bottom of the magazine, making sure it has seated properly, pull the charging handle all the way to the back ejecting any round that may be in the chamber and "racking" another round, and then sight in and pull the trigger, bang. This complex problem, why didn't my weapon fire, has been broken down and trained deep into the S1 of Marines. This allows them to quickly and almost effortlessly resolve what could be a life-threatening problem. A fun scenario would be to get an unfamiliar civilian and a basically trained Marine on the firing line and have the scenario happen simultaneously and observe the response. I imagine the civilian would hold the rifle, look at it quizzically, perhaps pull the charging handle back to look at the chamber, maybe pull the magazine out and make sure rounds are loaded, not realizing that an empty magazine will catch the bolt at the rear, who knows, they may even stare down the barrel to see if it is free and clear (I really hope not). The Marine will go straight into S1 and tap, rack and bang without realizing that they just resolved a complex problem with a three word "ditty." (We break down a lot of complex movements into dittys, thinking introspectively it is scary how many still get triggered for me.)
That whole scenario is just a complex way of saying that we can train S2 to become S1. We want to do this selectively, because it takes an investment of time and energy. If I take a relative shooting and we are firing one of my AR-15s, do I really want to put them through weapons drills to get "tap, rack, bang" down when they probably won't fire the weapon again after today? But I absolutely do want to train a Marine to "tap, rack, bang" because if they aren't firing their weapon at the enemy our suppressive fire is being degraded. I may get a return on investment from that Marine one day where I wouldn't from my uncle.
Where else can we do this? And how could this apply to investing? My initial thought turned to what is known as Rules Based Investing or Factor Investing. A simple search will uncover countless articles and books on the subjects, but all they really are is a framework to help guide us through the markets and take emotion out of decisions. Investors that rigorously apply these rules or factors are often called Quants. But you don't have to be a Quant to employ some rules to your investing. By coming up with some rules, using S2 of course, you can transition the bulk of your investing decisions to S1. This can be as simple as selling a company when it reaches a certain P/E or buying a company when it does the same. Many investors will sell a company who has cut its dividend without thinking twice. These rules, whatever they may be, is just a way of shifting S2 to S1, or maybe even S1.5.
The most common way for S2 to become S1 is through experience. The experience of watching the charging bear maul your friend is all it took to make any future encounters with a bear a S1 event, at least until the initial interaction is complete. But the experiences don't have to be personal ones. Not many of us have ever been charged by a bear, but we know what to do in that case. We have learned from the experience of others. I don't think anybody has ever said "this time its different" when watching a bear charge. Yet, we say this a lot when dealing with financial markets. Ahhh now the bear imagery makes sense!
One thing I have done personally is applied more discipline to my investing approach. This has resulted in me having a good amount of cash, I simply can't find investments that have made sense at this point. I haven't sold anything either, having learned my lessons selling early on several companies that went on to greater gains. I had the chance to learn from others, but this lesson I had to experience personally. The only thing I have really bought with an conviction this year has been the Emerging Markets ETF from Vanguard (NYSEARCA:VWO). Next up is the Europe ETF, and a few names in retail. Right now I'm working on putting my rules on paper and shifting my portfolio to follow these rules. If anything all this reading has done it has proven to me unequivocally that I don't know very much. Luckily for me, information is plentiful and the experiences of millions of other investors can help me.
What things in your life have you transitioned from S2 to S1 and how did you accomplish this? What would you want to transition and how do you think you will get it done? The possibilities are endless and exciting.
Disclosure: I am/we are long VWO.