Rational Thinking - Warren Buffett

Rational Thinking – How to think and invest like Warren Buffett

What is Rationalism?

Rationalism is the belief that one’s opinions or actions should be based on reason and knowledge rather than emotional responses. A rational person thinks clearly, sensibly, and logically. Rationality is not the same as intelligence. Smart people can do dumb things. Keith Stanovich, in his book “What Intelligence Tests Miss: The Psychology of Rational Thought”, coined the term dysrationalia. Dysrationalia is the inability to think and behave rationally despite high intelligence. Research in cognitive psychology suggests there are two principal causes of dysrationalia – the first is a processing problem, and the second is a content problem.

According to Stanovich, humans process poorly. There are different cognitive mechanisms to choose from while solving a problem. This article covers how a human thinking process works, and how to use it to avoid the mistakes most investors commit while evaluating a business. 

Two kinds of investment ideas

Treynor in his famous article “Long-Term Investing” discussed two kinds of ideas:

1. Ideas where the implications are straightforward and obvious, take little expertise to evaluate and consequently travel quickly

2. Ideas that require reflection, judgment, and special expertise for their evaluation, and consequently travel slowly

If the market is inefficient and there is a price-value gap to take advantage of, it won’t be with respect to the first kind of idea, since these ideas are straightforward and unlikely to be misevaluated by a great mass of investors. In other words, simple ideas like P/E ratio, PEG ratio, dividend yields, 52-week highs and lows, technical charts and ratios, and other elementary ways we can think about a stock are unlikely to provide easy or huge profits. 

Treynor quote : If there is any market inefficiency, hence any investment opportunity, it will arise with the second kind of investment idea -the kind that travels slowly. 

Warren Buffett’s investment tenets are ideas that travel slowly and relate to long-term business developments. They are the basis for long-term investing. The slow-moving idea is not intellectually difficult to grasp, but it is more laborious and requires mental effort than relying on “straightforward and obvious”.

System 1 and System 2 thinking

System 1– System 1 thinking is quick and associative cognition. Here simple and straightforward ideas travel quickly. It takes little time and does not require much intellectual work. For example, the calculation of the Price-earnings ratio, and dividend yield is very straightforward and falls under System 1 thinking.

System 2– System 2 thinking is the reflective part of our cognition process. It operates in a controlled manner, slowly and with effort. This mode of thinking requires sound judgment and special expertise to make it more effective.

Many people seem satisfied with the initial quick answer they arrive at using System 1 thinking, that they never bother to use System 2 thinking. Many people, including intelligent people, have the tendency to get lazy when the task gets harder. People rush to System 1 without deploying a much more laborious System 2. 

System 2 thinking requires self-control, and continuous exertion of self-control could be unpleasant. If we are continually forced to do something over and over that is challenging, there is a tendency to exert less self-control when the next challenge arrives. Those who overcome this, are more engaged in the tasks where they apply their thinking. They are more alert, more intellectually active, less willing to be satisfied with superficially attractive answers, and more skeptical about their intuitions.

An investor requires high engagement in System 2 thinking. This stream of thinking is strong, vibrant, and less prone to fatigue. It is so distinct from System 1 thinking that psychologist Keith Stanovich has termed the two as having “Separate minds”. But these two are not entirely separate. For System 2 thinking to work effectively, it must be adequately armed with the required understanding of a company’s competitive advantages, the quality of the company’s management, important economic drivers that drive a company’s value, and psychological lessons that prevent an investor from making foolish decisions. For this required understanding and to arm System 2 thinking with the adequate knowledge base, System 1 thinking is required.

System 2 thinking requires serious thought and patience. It is deliberate and requires concentration. Warren Buffett’s tenets are best suited for System 2 thinking, not the rapid-fire decisions involved in System 1.

Mindware Gap 

One of the causes of dysrationalia is the lack of adequate content for System 2 thinking. Psychologists refer to this content deficiency as a mindware gap. 

Mindware is all the rules, strategies, procedures, and knowledge people have at their mental disposal to help solve a problem. It is anything a person can learn that extends the person’s general powers to think critically and creatively. For investments, the mindware required to activate System 2 thinking would be the Annual report, Intrinsic value calculations, scuttlebutt information, capital allocation strategy, etc.  All this does not require a very high IQ, but it is more laborious and requires more mental effort and concentration than simply figuring out the company’s P/E and other ratios.

To effectively use rational thinking, the investor should employ both the System 1 and System 2 modes of thinking. The results may not reflect overnight, but the probability of success is much higher. For long-term success, the investor should be patient while evaluating the business, employing both System 1 and System 2 thinking. Most importantly, given the fundamentals of the underlying business are strong, the investor should be even more patient in letting the market prices reflect the underlying value of the business and generate profits.  

Read the value of Patience in investing here -> The Value Of Patience – Warren Buffett’s Key To Successful Investing

Leave a Comment

Your email address will not be published. Required fields are marked *