Two brains tracking fluctuation.
Analysis calls for caution;
Intuition calls for action.
Analysis causes paralysis;
Intuition causes emotions.
Use both intuition and analysis;
You’ll find great businesses.
Intuition leads with idea generation;
Analysis follows with deep calculation.
High probability insight occurs
when analysis agrees with intuition.
Seth Klarman: How Brains Could Fool Us
By MATTHEW INDYKE and BRIAN ZEN
Why is our own brain often our biggest enemy with investment decision making? What causes our errors in judgment? If you have played chess, you would know that the hardest part is choosing between what quick intuition tells you and what deep analysis tells you. Holding unpopular stocks like Hewlett Packard (HPQ), Seth Klarman, in his 2011 letter to Baupost Group partners, quoted psychologist Daniel Kahneman’s the two-brain-framework for explaining how the brain works. The hard part is how to hone both our intuitive insights and our analytical skills to make better decisions.
Do We Have Two Brains?
Kahneman visualizes the human brain as two separate systems. They are called system one and system two. System one is the intuitive brain. It thinks on the spot. It responds to commands without hesitation. It makes decisions quickly and unconsciously. We use system one when doing basic elementary math, such as 1 + 1 = 2.
System two is slower and more analytical. We have to think hard and long to find out that 62 x 78 = 4836. We need to remember what we were taught. We need to recall any past experiences that might influence how we approach a situation. System two is activated when doing complex calculations like those involved in financial statement analysis.
Understanding how our brains work is important to successful investing, says Seth Klarman. That includes knowing our mental limitations and internal biases. Know the maximum loss you are willing to accept and whether your perception of a company can one day be understood by others.
Should We Listen to Intuition?
System one helps us differentiate the good from the bad and the right from the wrong. We need it to control who we are and how we go about our daily routines. The people we interact with and the food we eat are processed by system one. The laws we follow and our ethical judgment are processed by system one. It keeps us sane and in touch with society. But system one is vulnerable when jumping to conclusions on a complex idea that seems so basic from the naked eye.
As an investor, you get up in the morning and you go to work. The process was completed using system one. But then you get to work and check the financial markets. You observe that the market is going up. Immediately, you get into buying mode and aggressively pursue stocks to buy. A novice investor likely uses intuition alone to guide its decisions. More experienced investors will tell you that doing this is not enough.
Seth Klarman notes that the errors associated with intuition alone can especially be avoided when operating as an organization rather than an individual. More investing minds create more ideas and help identify the ones that are insightful. Your intuition is valuable in terms of helping you sense the steps to get there and what to look for. But digging deeper into those details is another step required by the analytical part of the brain.
How Far Does Rationalization Go?
System two avoids following intuition only. Thorough analysis is necessary to solve a problem and answer a question. Knowledge will not be second nature to us. We have to think hard using a previously taught process ingrained in our brains. We have to be taught how to get there. We have to know how to get there. We have to remember how to get there the right way. And most of all, we have to think before we react. The educational knowledge and real world experience that we gain over the years expects to become the basis of our decisions. A seasoned investor like Klarman stresses that a company’s underlying value varies greatly from its actual price. Price is determined by supply and demand but value looks at factors like the amount of cash flow and assets a company possesses. A novice investor most likely makes an investment decision immediately after seeing favorable statistics. But system two cannot be ignored as it is necessary to further analyze the statistics. It requires more focus. And it requires deep analysis.
Why Do Smart People Sometimes Do Crazy Things?
System one or intuition could misguide us. Common sense makes us believe we can never make irrational decisions. But Kahneman suggests that most of the time, we later regret most of our decisions if we go only by intuition. So we need to be conscious of how our minds process information. A common mistake is to react quickly on what appears to be favorable circumstances. Ask any group of experienced investors and they most likely agree with Kahneman. The average investor will tell you there is a greater likelihood we don’t see high returns on our investments if we don’t spend sufficient time analyzing beforehand.
Seth Klarman knows that we need to train our brains to think a specific way in order to develop our investing skills. He goes on to mention that it is easier to predict how investors will react in a particular situation than it is to know a company’s bottom line. In other words, value investors may have better odds predicting behavioral shifts in investors’ mentality.
Intuition vs. Analysis: The Two-Brain Framework
Is system one’s intuition always reliable and accurate? Not entirely. All investors, novices or experts, are prone to following their intuition at any given time. Novices suffer from lack of experience. They haven’t seen the movie before. Experts may become arrogant and believe they are making a good investment because every past investment has worked.
Smart investors recognize that every good idea needs evaluation. That is where analysis comes in. It is rare for novices to be successful using system two. They generally require the experience of having done it before. Expert investors will presumably be effective with analysis. Their effectiveness is hindered when pride sets in or they become lazy. It is always necessary to think hard about the problem and how the idea applies in the real world.
Intuition is the beginning. It creates our raw thoughts. The thoughts become ideas. Analysis expands on the ideas. It brings out the details. It applies the ideas and details together. It thinks logically. Intuition and analysis, smartly used, will translate to high probability insights and profits.