A colleague suggested that I read Daniel Kahneman’s Thinking, Fast and Slow as a way to explore the wiring of our minds regarding decision making. I was not disappointed. Kahneman is a former Nobel Laureate in Economics. His work is the progeny of other pieces, such as “Freakonomics,” which studies the human psyche and how it makes choices. Kahneman’s current best-selling book centers on the two systems that regulate our thought functions and the way we evaluate our life alternatives.

System one is mainly structured around our intuition. It is reactionary, and an amalgam of our own collective experiences, as well as what is naturally wired in us as human beings. Think of it as the brain’s RAM adjusted for “fight or flight” and modern social convention. System two is a more careful, analytical engine that allows us to give greater thought to our everyday selections. It is described as the system that basically “looks, before it leaps.” It is an arrangement of gray matter that serves as our arbiter, giving finality and concentration to our beliefs. While this may not be the first time an economist or a psychologist has written about such competing methods, Thinking, Fast and Slow serves as a tour de force that delves into the innumerable ways that we choose.

This book is essential reading for anyone, though it is especially salient for the money manager. One of the keys when making financial decisions is to eventually review one’s investments post mortem, so to speak. A work like this explores the different avenues that affect our predilections. For example, Kahneman suggests that we tend to frame our risk set based on factors such as loss aversion, more recent experiences and stereotypes or biases. In one instance, he writes about investors who tend to flock to stocks that have been in the news. He also addresses our insistence on selling “winners” while hanging on to losing investments in the hope of recouping our losses and damaged egos. Ultimately, what Kahneman advocates is a cold, hard look at our own body of work. How much of our success is due to true insight and hard work and how much is luck? After all, as we have already suggested in past articles, an approach that favors securities with real value, or arbitrage possibilities, consistently works in the long run. This discipline requires a certain degree of focused analytics and not the good fortune that trends or momentum rewards. Granted the old saw, “it is better to be lucky than smart” or “you can marry more money in an hour than you can make in a generation,” still apply. Nevertheless, it is still important to rely on a cerebral algorithm that tests assumptions, without prejudice, and adjusts for noise due to presumption.

More fascinating still, is Kahneman’s view that we set many of our choices around our own narrative. A storyline that is based on a plot we continually write for ourselves. In this way, we lend a halo effect to those options that resonate with who we want to be, or what we aspire to. We tend to overweight candidates that are attractive to us, rather than ones that are fundamentally sound. In fact, it clearly reminded me of the central premise behind Michael Lewis’ much acclaimed Moneyball. In Moneyball,baseball’s general managers and scouts preferred ballplayers that had a “pro body,” Players who compiled statistics that qualified them, yet with the additional benefit of looking like Mickey Mantle. Lewis’ protagonist, Oakland A’s general manager Billy Beane, upends this technique by using statistical analysis to choose players when drafting. His legacy is a team that saw relative triumph on a meager payroll while competing with payroll giants like the Yankees. To Kahneman’s credit, he concedes that talent and good looks should never be ignored; however, we must stick to the numbers. I apply this to the latest fascination with certain “black box” theory which has proved time and again to eventually run its course. It seems the Warren Buffets of the world win, where others do not, by considering all aspects of a trade using a strong dose of reality. In essence, that is what Thinking, Fast and Slow endorses, and I find it hard to argue with that line of reasoning.

Kahneman allows for the intangible and non-analytical, and that is what makes him special. He gives discourse on the great benefit of optimism which runs contrary to his thesis. Optimists tend to get over failure much quicker than most and is what makes them valuable entrepreneurs and creators. Optimists sometimes ignore the obvious risks. For instance, it was Edison’s insistence on trial and error that brought us the light bulb. In Thinking, Fast and Slow, we see that reality takes care of the constant concerns while optimism and originality inspire greatness.

It would be too exhaustive to explore all of the circumstances that this tome uses to describe our inner workings. Suffice to say it has been selected for many “must read” lists and justifiably so.

The journey one makes with Kahneman is that of reflection, and a contemplation of our brain’s flow chart. It definitely belongs on every serious investor’s book shelf. It should be read and re-read, and applied to our judgments, both in the financial arena and beyond. Having said that, it is also an entertaining and thought provoking read—and you may learn something, despite your inner tendencies.

Thinking, Fast and Slow, by Daniel Kahneman. Farrar, Straus and Giroux, Publisher.

One more thought….

At the risk of lavishing you, we will give you some additional food … or coffee … for thought. Another stock which has been a great performer and still has some real potential, is Starbucks (SBUX)—$47.36 last sale, as of the close 1/13/12. From a fundamental standpoint, you might shy away seeing that it sports a price-to-earnings ratio of 29 and is at an all-time high, stock price-wise. However, you cannot ignore the fact that the company’s marketing strategy during this economic crisis has been brilliant. Walk into most, if not all, of its stores and what you see is a modern day agora or town square. Starbucks produces a great product, and for a few more dollars the customer gets the illusion of pampering and exclusivity. More important is its successful foray into loyalty, or “frequent flier” cards. Combine this with a real presence in social media, and you have a sustainable growth formula that speaks to today’s economy. Of course, we will follow up on this idea. Nevertheless, we feel there is more upside here. For the faint of heart, take a look at the July Call Option Series struck at, or above the market. As for us, we will take ours plain, no sugar and go with the common.

—The Thoughtful Arbitrageur

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.

This entry was posted on Wednesday, January 18th, 2012 at 3:34 pm and is filed under The Thoughtful Arbitrageur. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.