ILLUSTRATION BY CHRIS NICHOLLS
generally takes its cue to engage in effortful thinking from error-prone System 1.
Although it may be tempting for investors to try to overcome these biases on their own, they should know that over-riding the impulses of System 1 goes against its pursuit of
efficiency, which more often than not seems to win.
On the surface, this might seem like a major design flaw,
though it’s more likely the case that the mind balances System
1 and System 2 thinking fairly well for everyday tasks where
there is plenty of opportunity for practice and feedback. To
illustrate this point, you know right away if you’ve burnt the
toast, and you will subsequently (we hope) turn your toaster to
a lower setting the next time around.
Not Enough Practice?
In contrast, for the average investor, making decisions about
their financial future not only happens less frequently compared to everyday tasks, such as preparing breakfast, driving
to work, or performing one’s job, but there is also less opportunity to learn from mistakes.
Most Americans understand that saving and not overspending are important, but they find being disciplined in implementing this knowledge easy to put off until “next month’s
paycheck.” Why? Because the most important consequences of
putting them off aren’t necessarily experienced until decades
later when they want to retire or have an unexpected life event
such as a sudden decline in their health.
Financial advisors regularly tell me how amazed they are by
the number of clients who are unaware of how much more quickly they can pay off their home by making one or two extra mortgage payments a year or how waiting to cash in on Social Security
until age 70 can make these funds go significantly further.
Recognizing the benefits of compound interest does not
come naturally for most people regardless of how their System 1
and System 2 work — it’s a concept that instead requires knowl-
edge, experience, and expertise to fully grasp and apply.
Thus, the need for sound financial advice is still more apparent
than ever, but, looking into the future, the role probably will have
a greater emphasis on managing behavior due to several decades
of behavioral research finally making its way into popular press
thanks to Kahneman’s “Thinking, Fast and Slow,” and Richard
Thaler’s “Misbehaving.” Both books provide a terrific overview of
cognitive biases that financial advisors would find useful.
From Theory to Action
There is merit and practical application that extends beyond
Kahneman’s original intent, who presents the System 1 and
System 2 framework as internal mental (cognitive and perceptual) processes.
First, System 2 can be externalized or “outsourced,” meaning outside sources of feedback, such as financial advisors, can
serve as proxies for deliberative, effortful, and logical thought,
or at a minimum serve to snap individuals out of the allure of
System 1 (impulse and emotion).
Second, a person’s personality and environment (e.g., cultural and generational influence) play a role in shaping System
1. That insight into these forces can help financial advisors
serve their clients more effectively.
The Influence of Personality
Since the mid-1990s, personality research has been getting a
“second wind” thanks to a renewed interest in the subject, better methodologies, and the appeal of broad application. Prior to
this time, research in personality was arguably overshadowed by
what psychologists referred to as “behavioral and cognitive revolutions” — the latter of which led to many of the breakthroughs
discussed in the previous section pertaining to cognitive biases.
Personality research will significantly contribute to the next