A pen and a pencil together cost $1.10. The pen costs $1.00 more than the pencil. What’s the price of the pencil?

If we had not seen this example before, most of us would be tempted to respond that the pencil costs 10 cents. But if we pause and take a couple of seconds more to think, we’ll quickly realize that the pencil actually costs 5 cents, while the pen is priced at $1.05.

So, why do we often fall for the 10-cent trap? It happens because of a fascinating phenomenon in our cognitive processes known as “System 1 thinking.”

Daniel Kahneman, the Nobel Laureate proposed the theory which is widely accepted that we have two forms of thinking – System 1 and System 2.

 

 

 

 

 

 

Tying our shoelaces, taking the elevator to the office or instinctively hopping over a puddle on the sidewalk are all done through System 1 thinking.

On the other hand System 2 thinking is used for tasks that require mental effort, complex computations making informed choices, etc.

Systems 1 and 2 are both active whenever we are awake. System 1 runs automatically and System 2 is normally in a comfortable low-effort mode and it is activated when System 1 calls on it for some task. Both are equally important and need to work together for effective decision making.

How are System 1 Thinking and System 2 Thinking applicable to personal finance?

Imagine an investor who is considering to make an investment in a stock. Their initial reflex might involve a quick scan of metrics like the PE ratio, price range, dividend yield, and a glance at today’s news. If the PE ratio looks attractive, the dividend yield is appealing, and there’s no red flag in the latest news, the investor’s intuitive “System 1” thinking might instantly tag it as a sound investment.

However, what if “System 2,” the more analytical and deliberative part of the investor’s mind, was brought into play? In that case, the investor might delve deeper, examining factors like the competency of the management team, the long-term growth prospects, and conducting a thorough review of the company’s financial statements. As investors, it’s crucial to train our minds to seamlessly transition from System 1 to System 2 thinking. This transition ensures that we allocate sufficient time for thoughtful deliberation, actively seek out information, and consider all the pros and cons before arriving at an informed investment decision.

When it comes to personal finance, we tend to love status quo. We tend to clint to the familiar, opting for the same bank as our parents, investing in the same products that we have always been comfortable with. Even when we receive a raise, very  few of us take action to increase the savings rate proportionately. This behaviour is attributed to System 1 thinking.

Thoughtful Financial Decision Making

System 1 thinking efficiently processes routine decisions and helps us navigate the complexity of daily life. However, when it comes to our financial well-being, it may not always serve our best interests. This is where “System 2” thinking steps in—a more deliberate, analytical approach to decision-making. To make sound financial choices, it’s essential to train our minds to activate System 2 when needed. So, how can we prompt the shift towards more thoughtful financial decision-making? Here are some practical tips to engage System 2:

• Set-up quarterly or annual reminders to do a financial review, Use this time to revisit your savings and spending percentages, check the status of your retirement fund, and assess your overall financial health.
• Establish automatic step-ups to contributions to investments and/or Systematic Investment Plans (SIPs).
• Introduce guardrails in your spending and investment decisions.. For instance, when trading, it’s wise to set stop-loss and take-profit limits to prevent impulsive decisions driven by market fluctuations.
• Create and follow a shopping list to avoid impulse purchases. Whether you’re at the grocery store or browsing online, having a predetermined list helps you stay focused on essentials and prevents unnecessary splurges.

 

While System 1 plays a critical role in decision-making and protects us from cognitive overload, it makes sense to engage System 2 in financial decisions. By intentionally involving System 2 in financial choices, we empower ourselves to make more informed and advantageous decisions, ultimately working toward our financial goals with greater purpose and precision. so that we make more informed money decisions ultimately working toward our financial goals more smartly.