Equities  

Strive to be mindful of mental shortcuts

The human brain is a funny thing and works in ways that are not always sensible and rarely easy to understand.

As a way of addressing this point, the Nobel Prize-winning behavioural theorist Daniel Kahneman has written about ‘system one’ and ‘system two’ – what we might effectively think of as the subconscious and conscious parts of the human brain.

According to Kahneman, our ‘system one’ subconscious reacts and makes decisions automatically for a variety of sound evolutionary reasons and does so with little effort or indeed understanding on our behalf.

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Meanwhile, our ‘system two’ conscious is involved in all our deeper thinking but is also inherently lazy and would rather do nothing if an instantaneous judgment were available from our subconscious.

Therefore, when we are asked a difficult question, we will often subconsciously ‘flip it’ so it is considerably easier to answer.

‘How happy are you with your life these days?’ is actually a tough question that involves a degree of thought so we subconsciously jump to a slightly easier one – ‘How is my mood right now?’

Similarly, if you were asked how popular David Cameron is likely to be going into the next general election, you would not really weigh up everything that might occur between now and 2015. Instead, your mind would factor in how popular Mr Cameron is today and extrapolate from that.

Even if you are not addressing the question actually posed, your subconscious does this without you realising and the conscious part of your brain does not debate it enough to bother putting up a fight.

In the world of investing, this means when someone is asked whether they see Tesco, for example, as a good investment, their answer is more likely to address the subtly different question of how they ‘feel’ about Tesco.

Depending on who they are, that might lead them to focus on, say, the group’s US strategy or the fate of its smaller rivals or even the contents of its burgers but, in all likelihood, their answer will be based more on emotion and gut reaction than the altogether trickier matter of whether Tesco may or may not be a good investment.

The real answer to whether Tesco will be a good investment will, of course, be dictated almost entirely by numbers yet the brain prefers not to get involved with such complexities. It will switch instead to more ‘touchy-feely’ considerations such as brands or pricing power or logos or indeed, in modern-media terms, anything that can be illustrated with a pretty picture. But all these factors are irrelevant in the assessment of the potential quality of an investment.

The key considerations as to whether or not a company is likely to be a profitable investment are its valuation and the health of its balance sheet. Understanding that and the limitations of the human brain are the first steps to being able to circumvent some of the mental shortcomings that have evolved in all of us.