If you ever watched Star Trek as a child you will doubtless recall Mr Spock. Famously portrayed by Leonard Nimoy in the original series from the late 1960s, Spock is one of the most iconic and enduring characters in science fiction.
Half-human and half-Vulcan, Spock had a distinctive appearance, with pointed ears and raised eyebrows. This mixed heritage often made him a figure of internal conflict, balancing human emotion with Vulcan logic and stoicism.
Dr McCoy, on the other hand, was very much a human being. He was compassionate and emotional, and frequently became exasperated by Spock’s insistence on logic and reason.
So, you may be thinking, what does Star Trek have to do with investing?
Well, the difference between these two Star Trek characters actually tells us a great deal about how investors behave, as author Tim Hale explains in the newly-published fourth edition of his book Smarter Investing. Although some investors are more like one or the other, there’s an element of Mr Spock and Dr McCoy in all of us.
Two ways of thinking
Let’s take a step back. Human beings think about things, process information and make decisions in two different ways.
The first is called the R-Reflexive System, or System 1. This system is fast, automatic, intuitive, and often unconscious. It's responsible for our immediate reactions to stimuli and quick, effortless decisions. It doesn't require much cognitive effort and often relies on mental shortcuts and past experiences.
System 1 is effective for routine tasks and in situations where quick decisions are necessary. However, because it’s neither thorough nor analytical. it can also lead to biases and errors in judgement.
Investing provides an excellent example of an activity in which people rely too heavily on System 1 thinking at their cost. It’s far better for investors to use the C-Reflective System, or System 2.
In contrast to System 1, System 2 is slow, effortful, deliberate and conscious. It's engaged when we are solving complex problems, making decisions that require careful consideration, or when we need to override our initial impulses. This system is more logical and analytical, taking a range of factors and possibilities into account before reaching a conclusion.
The downsides of System 2 are that it’s more cognitively demanding and is usually slower. But the big advantage of it is that it’s less prone to biases and errors than System 1.
System 1 usually trumps System 2
Both of these systems evolved for our protection. But we often automatically revert to emotional decision-making when logical thinking might be more appropriate.
To illustrate the point, Hale uses the analogy of visiting the big cat house at a zoo. “Imagine.. a lion you are looking at suddenly jumps at the bars you are standing by,” he writes. “Your immediate response is likely to be to scream and jump away, despite the logical response being that there is no need to do so, because it is safely behind a set of thick steel bars. In evolutionary terms, you are better off being quickly wrong than slowly right!”
There are various reasons why we revert to System 1 when thinking about investing. For example, the financial markets and the economic, political and behavioural factors that influence them are highly complex, and the information we rely on is incomplete and constantly changing. We also have competing needs; for example, we want to preserve our capital, and yet we also need to take sufficient risk to meet our long-term investment goals.
But the fact is, we need to make a conscious effort to apply System 2 before making investment decisions. In short, we need to look to our inner Mr Spock for guidance.
How to channel your inner Spock
The problem is, overcoming our evolutionary instincts can be very hard. So how can you go about it?
Well, some helpful suggestions are contained in the classic book Thinking Fast and Slow by Daniel Kahneman, the behavioural psychologist who originally devised the notion of System 1 and System 2 thinking.
For Kahneman, the first thing you need to do when making an investment decision is to acknowledge how little you actually know. The most rational approach is to be broadly diversified. "Diversification is an explicit recognition of ignorance,” he writes. “And it is often the right decision, precisely because the future is so difficult to foresee."
Kahneman encourages us to beware of our behavioural biases, and particularly overconfidence. He also warns against the negative impact of loss aversion, the tendency investors have to feel the pain of losses more acutely than the pleasure of gains.
He urges investors to avoid mental shortcuts that simplify decision-making but can lead to systematic errors. These include the anchoring effect (relying too heavily on the first piece of information we encounter) and confirmation bias (favouring information that confirms our existing beliefs).
Kahneman also cautions against narrative fallacies, stories or explanations constructed to make sense of complex situations.
But his most important lesson of all is to practise critical thinking. We should cultivate the habit of questioning assumptions and examining evidence critically, he argues, rather than making decisions based on intuition or other people’s opinions.
Work with an evidence-based adviser
Here at rockwealth, we would add one more suggestion for ensuring your investment decisions are rational: find yourself a financial planner.
But be selective. Choose an adviser with evidence-based investment philosophy, and who understands the behavioural biases that all of us suffer from.
With that, it’s time to sign off with Mr Spock’s signature Vulcan salute. And let’s not forget his famous catchphrase: "Live long and prosper."
FIND OUT MORE
Want to find out more about rockwealth Aberdeen and how we can help you to achieve your goals? Then give us a call or send us a message. We would love to hear from you.
Logic beats emotion in investing too, which is why we favour disciplined, long-term investing and long-term planning for retirement. Talk to financial advice you can trust.
