System 1 Vs System 2 Thinking Essay

Psychologist, Daniel Kahneman describes two methods of cognitive processes at work when individuals make decisions. The two-system approach to judgment and choice is described as System 1 and System 2 thinking. System 1 is the fast, automatic, associative and emotional process of decision making. System 2 is described as a slower, serial, effortful and deliberately controlled process. The System 1 process is intuitive and governed by habit and instinct, while System 2 thinking is more methodical, requires reasoning and governed by rules. Most thoughts originate in System 1, although System 2 takes over when more reasoning is required.
The ease with which mental contents come to mind is referred to as accessibility. Several factors influence the accessibility of information, both in perception and in judgment. For example, natural assessments such as size, distance, similarity or the difference between good and bad don’t require much effort to assess. This type of information is processed immediately. Some operations of accessibility require more effort and time due to experience, or lack thereof, and skill. The importance of the information and the way the information is displayed influences the

impressions that become accessible in a given situation.
Dr. Kahneman and Dr. Amos Tversky created an aspect of behavioral economics called prospect theory. Prospect theory is a theory of how people form decisions concerning prospects. A prospect is a gamble or a decision made regarding risk and uncertainty. The theory has ideas that challenge the rational-agent model. Prospect theory demonstrates that people think in terms of expected utility relative to a reference point, such as wealth. Prospect theory was developed by framing risky choices. The theory indicates that people are loss-averse, and since individuals dislike losses more than an equivalent gain, they are more willing to take risks, in order to avoid a loss. Within prospect theory, the value function represents how people value wealth. The weighting function infers how people psychologically deal with probabilities. Dr. Kahneman and Dr. Tversky determined that people do not weigh gains and losses the same. The psychologists also found that people’s value or utility diminishes as wealth increases. On the other hand, a far different effect occurs when losses are sustained. The reference point of prospect theory is a psychological point representing today’s wealth and the point where people estimate gains and losses; changes of wealth rather than states of wealth. Based on the presentation of information, the reference point is subject to manipulation depending upon how the information is framed. Framing, according to Dr. Kahneman and Dr. Tversky, focuses on the way material is presented. Accordingly, people can receive the same prospect; however, wording the prospect differently and suggesting a different reference point will alter people’s behavior.
The basic principle of framing is the passive acceptance of the options given.

Due to this passive view or narrow framing, people fail to understand the totality of a give situation. The rational-agent model assumes that investors make their choices in a comprehensively inclusive, broad framing manner, which factors all relevant details, including future opportunities and risk. In reality, investors have the tendency to evaluate their portfolios based on an extremely short time horizon. In addition, investor decisions about a particular investment are often considered in isolation of the total portfolio, especially if a loss occurs, as opposed to a comprehensive manner. Ultimately, short-term evaluations lead to excessive trading, increased portfolio expenses and

losses.
When addressing complex computations such as assessing probabilities and predicting values, people rely on a limited number of heuristic principles which reduce complex tasks to simpler judgmental operations. Theses cognitive biases include mental accounting, representativeness, anchoring, availability and affect.