Many moons ago, I watched a Manoj Shyamalan movie ‘Unbreakable;’ in which Bruce Willis played a security guard. He had an uncanny ability to pick up dangerous people during security checks by sensing their crimes.
We have come across some of these kinds in our everyday life. A ticket collector randomly pulls up a set of people in train and bus stations and surprisingly some turn out to be offenders. Unknowingly, we also use intuition in our day-to-day life – say to select our family doctors or partner. Can we use our hunch to also guide our investment decisions?
The Noble prize winner Daniel Kahneman in his book ‘Thinking, Fast and Slow’ challenged the fundamental idea that people are ‘rational’ in their thinking process. In contrast, he emphasized, errors are often inbuilt into our cognitive machinery.
He explains this with a ‘two-system’ machinery of thought:
System 1 which operates automatically and quickly without an effort – instinct and emotions come into play here.
System 2 in turn is slow, deliberative and more logical – where decisions are taken after effortful mental activities like research and complex computations.
War and …..? System 1 intuitively completes the answer. 2×2 is ….? is another example. The answer for these types of questions comes naturally from your collective intellect and memory.
In contrast, try answering the multiplication 16×39 or finding the number of ‘As’ in a sentence. Here, System 2 takes over by systematically counting or multiplying things to arrive at an answer, which requires a bit of concentration and effort.
Most of the time, Kahneman says, we think through System 1 which is prone to biases and errors. System 2 takes over only when things get difficult; otherwise, it simply obeys System 1.
In the market parlance, you pick a set of ‘value’ stocks after doing thorough research (using your System 2 that is). Shortly after buying, the market crashes and your portfolio falls as well. If fundamentally nothing has gone wrong, you should stay put. However, if you let your emotions overrule your thinking; you might be tempted towards ‘loss aversion’. Kahneman says it often does. In such a case, you go cash and try to time the market and probably miss the bus, whenever the tide turns.
That’s why simple algorithms used for decision making often can outperform some stock market experts that try to use their intuition in investing. It happens because experts can develop ego or biases while quantitative models don’t.
A rule-based investing process brings an element of discipline to investing and let not your emotions or faulty notions overrule your investing process. It systematically keeps overconfidence and knee jerk reactions at bay.
However, some also believe you need to ‘hear’ your inner voice, to be one up on the stock market. In the book ‘The Intuitive Investor’, the author Jason Voss says that it is intuition that lets us know what unique set of data are relevant from a nearly infinite set of information that bombards us every day.
While all kinds of number-crunching on companies are done by analysts, what about the new product that’s to be launched that could make or break its business? Or evaluating prospects of a new age industry or filling ‘data’ gaps?
As an investor you gather company information from diverse sources – be it suppliers, senior management, customers as well as equity analysts. You analyze and judge potential outcomes and assign possibilities that in turn help you to come up with potential gains and losses.
But it’s just one part of the work. An ‘alpha’ investor will also tap his intuition to figure out if the management is too optimistic or if the auditor’s comments need a further probe.
In short, the author believes the power of intuition along with that of the intellect (analysis in this case) can help investors see the world in ways that others are not seeing.
Albert Einstein once said that intuition is nothing but the outcome of earlier intellectual experience. So, a seasoned fund manager who has seen five market cycles of ups and downs is bound to react to a market crash with a lot more maturity than a market rookie. When his intuition is at free play, the former lets his accumulated experiences guide his decision-making.
Tapping intuition is however not that easy as often strong emotions overwhelm intuition (another System 1 dweller according to Kahneman). However, for individuals like George Soros, theory and instinct are inextricably linked. This investment guru vouches on the large play of his instincts in the investment process and for his success.
Only seasoned fund managers can hope to tap into their ‘instincts’ and be on top of the market. Most of the retail investors are better-off spotting them and investing in funds that they manage.