In his latest book, Thinking, Fast and Slow, the psychologist and Nobel economics laureate Daniel Kahneman argues that in some sense, we all have two brains: The ‘fast’ one that utilizes intuition, and the ‘slow’ one that bases decisions on rational, conscious thought. After reading this book, even those who pride themselves on being consistently rational will wonder how the fast brain influences every aspect of our lives, including investing.
Ignorance of the ‘fast brain’ can allow it to resurface at the worst of times—such as periods of extreme market anxiety or exuberance—leading one to invest in some quite irrational ways. Cultivating an awareness of how the fast brain functions can help us avoid the worst of its excesses. However, mastering the fast brain is painfully difficult. In his book, Kahneman even suggests that frowning more keeps the fast brain in check and helps people to think more rationally, but frowning too much clearly has its own drawbacks.
Fortunately, there is a more structured approach to understanding the fast brain. Kahneman’s ideas dovetail with the work of Benjamin Graham, the father of value investing. In his classic 1949 book, The Intelligent Investor, Graham recommends that investors have two separate portfolios: One for trading or speculation, and one for longer term wealth-building. One investment discipline that operates within this hybrid framework is the ‘core-satellite’ approach.
Based on this approach, investors can utilize their slow brains to establish asset-allocation in the core portfolio for long-term returns. Meanwhile, the fast brain can influence the satellite portfolio by taking short-term, tactical, or speculative positions.
Of course, building up a portfolio is a challenge in itself: It is easy to lose sight of the bigger picture in the face of so many investment decisions. The advantage of the core-satellite approach is that it helps investors synchronize their slow and fast brains. It makes the entire process—from setting initial risk parameters to evaluating performance—more systematic and transparent.
For private investors, the most important step in setting up a portfolio is conducting diligent risk-analysis, taking into account one’s individual investment goals and financial needs. One crucial element investors must remember with this approach is that the satellites should not exceed a certain share of the overall portfolio. Otherwise, they once again face the prospect of the fast brain taking over too many crucial decisions from the slow brain, making the overall portfolio unacceptably risky.
The core-satellite approach benefits investors through more effective information- gathering, portfolio decision-making, implementation, and monitoring. When short-term fear and greed crop up, these emotions can be accommodated in the satellite portfolio—which makes it more likely that investors will let rational thinking build their wealth in the core portfolio.