Should Investors Trust Their Gut?

Investors often talk about making a decision based on a feeling in their gut. Explaining how some form of unconscious intuition led them to the correct choice.  Although this is an appealing notion – particularly as people only seem to mention it following success – it can also be a dangerous one. Should investors really be trusting their gut and, if so, when?

In 2009, psychologists Gary Klein and Daniel Kahneman published a paper called: “Conditions for Intuitive Expertise: A Failure to Disagree”. This work was particularly notable as the two authors had seemingly ideologically opposed views on the subject of intuitive judgements. Klein had focused much of his career on how experts often make high quality, snap judgements; whereas Kahneman had famously highlighted the flaws and biases inherent in such short-term views (often referred to as system one thinking).

Despite these seemingly polar opposite opinions on intuition, Klein and Kahneman found that they concurred much more than they disagreed. Their common ground can tell us a lot about whether and when we should rely on our intuition.

Klein’s view on intuition is defined as the study of ‘naturalistic decision making’, the genesis of which came from the observation of chess grandmasters and their ability to make robust, instinctive decisions. This work expanded into other fields where similar expert intuition was found to be in evidence – such as a fire chief anticipating the collapse of a building, or a nurse rapidly identifying a child with a dangerous infection.

This type of expert intuition is a form of pattern recognition, where we draw on historic experience to the extent that it becomes an ingrained, unconscious feature of how we reach a judgement.

Contrastingly, Kahneman’s perspective was trained on heuristics and biases – how our instantaneous judgements are often partial, noisy and flawed. Such mistakes in thinking were made by esteemed and experienced experts such as clinicians, political forecasters and – unbelievably – investors.

In one instance we have individuals able to make strong intuitive judgements, even in stressful and uncertain environments; in another we have our intuitions leading us horribly astray. How can we align these seemingly diametrically opposed stances?

The answer is that whether or not we trust our gut is dependent on the context of the decision.

Klein and Kahneman agreed that there were two critical conditions, which needed to be in-place for expert intuition to be effective:

– It must be a ‘high validity’ environment: ‘High validity’ seems a somewhat impenetrable term but is relatively simple. To quote directly from the paper: “Skilled intuitions will only develop in an environment of sufficient regularity, which provides valid cues to the situation”. Good intuition relies on some form of stable relationship between cause and effect; these don’t have to be perfect but need to be reasonably predictable. Despite a chaotic environment, there are a set of signals that might indicate to a firefighter that a building is about to collapse.

– There must be an opportunity to learn: Intuition is about recognizing patterns, so we must have enough opportunities to learn those patterns and receive feedback. It is very dangerous to develop intuition based on small but highly salient examples.

It is easy to see how investors can fall foul of gut feel choices. We are constantly making decisions in low validity environments – where conditions are unstable, noisy and prone to change through time. The patterns we observe in one period may not repeat in another.

Does that mean that investors should never be led by their gut? Not quite. It depends on what the intuition relates to. If we have a feeling that we are about to enter another bear market for stocks, this is likely to be entirely erroneous – such views meet both criteria of where intuition fails us.

If, however, we have a gut feel that investing in an asset class that has risen stratospherically over the past year is likely to be a bad idea, this is more likely to be a smart intuitive judgment. Why? Because there is far more validity in this situation – regular historic patterns of assets with spectacular performance subsequently disappointing.

As Klein and Kahneman point out, high validity does not mean that every intuitive decision will be right, but they will put the odds on our side over time.

The challenge for investors is to know when to trust our gut and when to ignore it. We almost inevitably make more intuitive judgements than we care to admit. Often making up our mind immediately, before carrying out some more detailed (after the fact) work to disguise the real driver of our choice.

The other major issue faced by investors is the conflation of intuition and emotion. They are both decision-making factors that can lead us to act quickly, but they are very different. Making a choice based on fear, greed, anxiety or excitement can feel something like intuition but has little to do with pattern recognition and all to do with biology. We should always avoid emotion-laden investment decisions.

The relief for investors is that – unlike the firefighter or the nurse – most of us don’t have to make snap judgements, we have time on our side even if we often don’t act like it. This doesn’t mean we should entirely ignore our gut but use the time we have to think about what it is telling us and whether it is the right type of situation to trust it.

Kahneman, D., & Klein, G. (2009). Conditions for Intuitive Expertise: A Failure to Disagree. American Psychologist, 64(6), 515.

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