Alan S. Roth write in the Nov. 2 issue of Financial Planning
"In the real world, risk correlates with reward.... Our minds, though, are often
disconnected from reality, and we view risk and reward as disconnects."
"People base their judgments of an activity or a technology
not only on what they think about it, but also on how they feel about
If their feelings toward an activity are favorable, they are moved
toward judging the risks as low and the benefits as high; if their
feelings toward it are unfavorable, they tend to judge the opposite —
high risk, low benefit. Of course, the pattern isn’t logical, but it’s
how humans think."
"In his 2011 book, Thinking, Fast and Slow, Nobel Economics Prize winner Daniel Kahneman discussed our two ways of thinking:
System 1: Rapidly, automaticly, frequently, emotionally, stereotypically, subconsciously.
System 2: Slowly, effortfully, infrequently, logically, calculatingly, consciously.
Essentially, system one is rooted in how we feel, while system two
is, supposedly, rooted in logic. Two critical points, however, are that
both systems reflect how we think, and that we typically don’t know
which system we are thinking with. We assume we are always using logic
when making decisions."
"System 1 feels more pleasure and pain. It views the stock market as
high reward and low risk at the height of bubbles, and high risk and low
reward at the bottom.
System 2 always considers stock investing to be risky, but leads to
the conclusion that stocks are a better buy after a half-off sale than
after the price has doubled. Our thoughts also assess the high
probability that capitalism will survive. When stock prices reach an
all-time high, System 2 knows there is a low probability that stocks
will rise indefinitely without the arrival of a bear market."
"Research indicates that System 1 typically prevails in investing. Most
data show investor returns typically lag fund returns due to poor market
timing. Fund flow data reveal we buy more stock funds near the top
price and sell more near the bottom."
"Behavioral finance readily explains how we can think we are being logical while doing illogical things...."
Read Roth's full discussion at: