Cognitive Bias Series #4: The High Cost of Thinking with The Wrong Brain

By TradeSmith Research Team

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Did you know that you have two brains?

Or that “thinking with the wrong brain” is a problem investors face … which costs them a lot of money?

You don’t literally have two brains. It’s not like there’s a spare somewhere. But the human brain has two different “systems,” which Daniel Kahneman calls System 1 and System 2.

Kahneman is an Israeli-American psychologist notable for his work on the psychology of judgment and decision-making, as well as behavioral economics.

The two systems are so different from each other — and have such radically different jobs — that they’re the functional equivalent of having two different brains.

To put it another way, System 1 and System 2 are like two different operating systems that run on the same computer. (Your brain doesn’t work like a computer at all, but that’s a whole different topic.)

The systems have different characteristics.

System 1 is like an athlete. System 2 is like a chess player.

The athlete (System 1) is fast, responsive and intuitive. It decides quickly and moves quickly. It’s primed to make quick judgments, and act quickly on them.

System 1 is all about survival in the face of danger. If you’re hiking in a forest and come across a bear, System 1 is what floods your body with adrenaline … sends a surge of power to your muscles … and has you running at top speed or climbing a tree before your rational mind fully registers what’s happening.

System 2 is more like a chess player. It works slowly and deliberately and is capable of abstract thought.

System 2 moves like a tortoise in comparison to System 1. But System 2 is better at making complex judgments or solving hard problems.

System 2 is powered by a different part of your brain: the frontal cortex. Some call the frontal cortex “the CEO of the brain” because it controls executive function. It’s used to make conscious decisions.

When you do your taxes, you’re using System 2.

When you weigh the pros and cons of starting a business or buying a
house … and you mull the decision for months … you are using System 2.

Basically, when you come across a problem that requires thinking things through (a situation where help from a chess player would be more valuable than help from an athlete), you’re using System 2.

Most people use System 2 a far smaller percentage of the time than they use System 1. That’s because System 2 is “cognitively expensive.” It takes a lot of energy to run it.

The human brain is an energy miser by design.

This isn’t because the brain is lazy, but due to a built-in survival mechanism. The less energy you burn, the fewer calories you need. The fewer calories you need, the less food you have to eat. This was important in the era before grocery stores.

To save energy, the built-in preference of the brain — call it the “default setting” — is to use System 1 (fast and intuitive) as much as it can and System 2 (slow and deliberate) as little as it can.

This is the factory-installed set of habits that all brains start out with. (You can change these settings, but only with repetition and the formation of new habits.)

System 1 relies on something called heuristics. The word “heuristic” comes from ancient Greek, meaning “find” or “discover.” Heuristics are more commonly known as mental shortcuts. They’re also called “rules of thumb.”

For example: If you hear thunder, and the sky is cloudy, you may think: “It’s probably about to rain.”

That’s a simple heuristic — thunder plus gray skies mean likelihood of rain.

Over the course of a lifetime, System 1 collects tens (or even hundreds) of thousands of these heuristics and relies on them for quick, snappy judgments.

The heuristic-based judgments of System 1 have at least three benefits:

  • They are cognitively low cost (they don’t require much energy).
  • They provide immediate answers (a conclusion is usually built in).
  • They usually have an automatic response (if X happens, do Y).

The challenge for investors is that, when it comes to investing, the snap judgments of System 1 are all too often wrong or incomplete.

Important investment decisions are usually better served by System 2 — that slow, deliberate, and thorough process that is cognitively expensive. (The chess player versus the athlete again.)

Another problem is that System 1 is directly connected to the emotional center of the brain. This is a feature, not a bug, because emotion gets the body moving as a form of survival response.

Go back to the forest example — the hiker who stumbles across a bear.

If you’re hiking and meet a bear, System 1 routes feelings of panic directly into your body. These feelings are instant, pouring a flood of adrenaline into your muscles.

At the same time, your breathing either slows or stops, in preparation for an explosive burst of muscle activity. This prepares you to either run away as fast as you can, or to pick up some kind of weapon and fight for your life.

The problem is that not all bears live in forests. Some of them roam around in stock markets.

It’s possible to experience fear or danger in the stock market … which System 1 then responds to with the standard surge-of-emotion, fight-or-flight playbook.

The emotion doesn’t always have an “extreme” label. Not every situation is life threatening. But small dangers can trigger the same kind of fight-or-flight response on a minor scale. This is like hearing a rustle in the tall underbrush and getting nervous, then starting to wonder if you should run.

That’s where “thinking with the wrong brain” comes in.

You don’t want the emotional triggers of System 1 messing with investment decisions any more than you’d want a professional athlete giving you tax advice. It’s the wrong system for the job!

There are two simple ways to help with the problem of “thinking with the wrong brain,” or in other words, using System 1 when you’re supposed to be using System 2. These two simple things are:

  • Developing a clear set of rules, which exist outside your brain, for System 1 to rely on.
  • Reducing the cognitive expense of System 2 by using software.

Remember that System 1 uses heuristics, or rules of thumb, to make fast judgments that are often emotionally charged. This is a survival feature, in the same manner an athlete uses quick reflexes and fast judgments on a playing field.

But in complicated environments, it’s better to have an outside set of rules — a checklist, if you will — that the brain learns to rely on instead of System 1 judgments.

Top professionals use checklists in all kinds of fields. Pilots. Surgeons. Value investors. Navy SEALS.

Atul Gawande — the renowned surgeon now working to transform the healthcare industry with the backing of Jeff Bezos, Warren Buffett, and Jamie Dimon — even wrote a book on the value of checklists called “The Checklist Manifesto.”

Checklists are valuable in all kinds of situations, regardless of stress level. But when stress levels are high, the checklists become more valuable still — because the checklists keep System 1 from skipping a step or making a foolish move.

The second way to fix the “thinking with the wrong brain” problem is to use software that helps with the heavy lifting required of System 2.

As we’ve explained, System 2 is “cognitively expensive.” It takes a lot of energy to run. In our sleep-deprived world, that’s a big problem. Most people don’t have the spare energy to think about hard problems at the end of the day. (Or even in the middle of the day!)

But well-designed, easy-to-use software can do a lot of the heavy
lifting … making System 2 easier to use.

And we’re not talking about “software for dummies” here. The smartest people in the world routinely use software to help make big decisions.

For example: Did you know Google — or rather Google’s parent company, Alphabet — uses a software program to make decisions on venture capital investments?

Google is such a profitable behemoth, they could hire the biggest brains in the world for their venture capital arm (and they do).

Yet they still have analysts feed data into a software program to help make the calls. This helps with the heavy lifting of crunching all those variables. The software can also “see” patterns in the data that the human brain can’t.

TradeStops (and also Ideas by TradeSmith) does a similar thing for individual investors.

It uses algorithms to process big data sets — mountains of information that are too much for a human brain to sift through without help.

And it turns that data into a clear and simple framework for making better investment decisions.

So, remember that you have two brains (System 1 and System 2) … that System 1 is the athlete (fast) and System 2 is the chess player (slow) … and that System 1 should not be used for investment decisions.

Last but not least, there are two ways to fix the problem of “thinking with the wrong brain.” First, develop a set of rules outside your brain (preferably with a checklist). Second, use software (as many of the smartest people in the world do) to help lighten the load of System 2.

TradeSmith Research Team

Cognitive Bias Series