Information Processing

Module 2: Topic 1
Dr Sana Moid ,ABSL

1
 Session Outcome

• To understand the role of Information Processing in decision making by

individuals in general and by investors in specific.

• To understand the different types of Information Processing systems

operating in the individual’s brain: Rational. Intuitive Dual System and
Bayesian.

• To examine the impact of information processing system on financial

decision making

2
• Theories propose that reasoning comprises two underlying systems. The
systems are identified as having functionally distinct roles, differ according
to the type of information encoded, vary according to the level of
expressible knowledge, and result in different responses

• When we’re making decisions, we use two different systems of thinking.

System 1 is our intuition or gut-feeling: fast, automatic, emotional, and
subconscious. System 2 is slower and more deliberate: consciously
working through different considerations.

• Traditionally, logical thinking and intuition have been viewed as rival

modes of thought. The former is deliberate, achieving accurate and
justifiable representations of the world, and the latter is ineffable,
producing best-guess answers to problems without any discernable effort.

3
• Traditionally, logical thinking and intuition have been viewed as rival modes
of thought. The former is deliberate, achieving accurate and justifiable
representations of the world, and the latter is ineffable, producing best-
guess answers to problems without any discernable effort.

• System 1 (intuition) is more accurate in areas where we’ve gathered a lot of

data with reliable and fast feedback, like social dynamics. System 1
operates automatically and quickly, with little or no effort and no sense of
voluntary control.

• System 2 (rational)tends to be better for decisions where we don’t have a

lot of experience; involving numbers, statistics, logic, abstractions, or
models; and phenomena our ancestors never dealt with. System 2 allocates
attention to the effortful mental activities that demand it, including
complex computations. The operations of System 2 are often associated
with the subjective experience of agency, choice, and concentration.
4
 Example

• Let’s take one decision everyone has to make at some point: choosing a
career. The decision can be broken down into parts, some are more
appropriate for System 1 reasoning, and some are appropriate for using
your System 2. With your system 1 you might tackle questions like, “Will I
get on with the people I’d be working with in this job?”, or “Will this
working environment help me to work productively?”.

• And certain questions seem best analysed with System 2: “Where will I
build the most valuable skills?”, “What factors correlate most with job
satisfaction?”, “Which organisation is growing the fastest?” System 2
reasoning is also better for weighing all the relevant factors and eventually
making your career decision because in order to get enough data to have
reliable feedback, you would need to have had experience making
hundreds or thousands of these decisions
5
• We also use these 2 processes for making decisions about what is moral or
ethical behaviour, what Jonathan Haidt, who conducted much of the
original research, has called social intuitionism. He found that moral
judgements are made predominantly on the basis of intuition and, when
prompted, we use our System 2 to provide a rationalisation, and only
rarely do people use conscious reasoning beforehand.

6
7
 Thinking, Fast and Slow!!

• Israeli-American psychologist and Nobel Laureate Daniel Kahneman is the

founding father of modern behavioral economics. His work has influenced
how we see thinking, decisions, risk, and even happiness.

• In Thinking, Fast and Slow, his “intellectual memoir,” he shows us in his

own words some of his enormous body of work.

• Part of that body includes a description of the “machinery of … thought,”

which divides the brain into two agents, called System 1 and System 2,
which “respectively produce fast and slow thinking.” For our purposes,
these can also be thought of as intuitive and deliberate thought.

8
• If asked to pick which thinker we are, we pick system 2. However, as
Kahneman points out:
• The automatic operations of System 1 generate surprisingly complex
patterns of ideas, but only the slower System 2 can construct thoughts in
an orderly series of steps . I also describe circumstances in which System 2
takes over, overruling the freewheeling impulses and associations of
System 1. You will be invited to think of the two systems as agents with
their individual abilities, limitations, and functions.

9
 System 1: Quick

• These vary by individual and are often “innate skills that we share with
other animals.”

• We are born prepared to perceive the world around us, recognize objects,
orient attention, avoid losses, and fear spiders. Other mental activities
become fast and automatic through prolonged practice. System 1 has
learned associations between ideas (the capital of France?); it has also
learned skills such as reading and understanding nuances of social
situations. Some skills, such as finding strong chess moves, are acquired
only by specialized experts. Others are widely shared. Detecting the
similarity of a personality sketch to an occupational stereotype requires
broad knowledge of the language and the culture, which most of us
possess. The knowledge is stored in memory and accessed without
intention and without effort.

10
 System2: Deliberate

• This is when we do something that does not come naturally and requires
some sort of continuous exertion.
• In all these situations you must pay attention, and you will perform less
well, or not at all, if you are not ready or if your attention is directed
inappropriately.
• Paying attention is not really the answer as that is mentally expensive and
can make people “effectively blind, even to stimuli that normally attract
attention.” This is the point of Christopher Chabris and Daniel Simons in
their book The Invisible Gorilla. Not only are we blind to what is plainly
obvious when someone points it out but we fail to see that we are blind in
the first place.

11
 Division of Labour Between System One and Two

• 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,
in which only a fraction of its capacity is engaged. 

• System 1 continuously generates suggestions for System 2: impressions,

intuitions, intentions, and feelings. If endorsed by System 2, impressions
and intuitions turn into beliefs, and impulses turn into voluntary actions.
When all goes smoothly, which is most of the time, System 2 adopts the
suggestions of System 1 with little or no modification

12
• When System 1 runs into difficulty, it calls on System 2 to support more
detailed and specific processing that may solve the problem of the
moment. System 2 is mobilized when a question arises for which System 1
does not offer an answer, as probably happened to you when you
encountered the multiplication problem 17 × 24. You can also feel a surge
of conscious attention whenever you are surprised. System 2 is activated
when an event is detected that violates the model of the world that
System 1 maintains.

13
• Overcoming?

• System 1 operates automatically and cannot be turned off at will, errors of

intuitive thought are often difficult to prevent. Biases cannot always be
avoided, because System 2 may have no clue to the error. Even when cues
to likely errors are available, errors can be prevented only by the
enhanced monitoring and effortful activity of System 2. As a way to live
your life, however, continuous vigilance is not necessarily good, and it is
certainly impractical. Constantly questioning our own thinking would be
impossibly tedious, and System 2 is much too slow and inefficient to serve
as a substitute for System 1 in making routine decisions. The best we can
do is a compromise: learn to recognize situations in which mistakes are
likely and try harder to avoid significant mistakes when the stakes are
high. The premise of this book is that it is easier to recognize other
people’s mistakes than our own.

14
System 1 System 2
Does nor require working memory Requires working memory
Autonomous Cognitive Decoupling, mental
stimulation
Fast Slow
High Capacity Capacity Limited
Parallel Serial
Non Conscious Conscious
Biased Responses Normative Responses
Contextualised Abstract
Automatic Controlled
Associative Rule Based
Experience based decision making Consequential decision making
Independent of cognitive ability Correlated with Cognitive Ability
15
 Bayesian information processing

• Economic models of decision-making rely on several important paradigms.

Two of them are particularly important. First, decision-makers’ choices can
be represented by well defined utility functions (satisfying well-defined
axioms). Second, decision-makers are Bayesian processors of information.

16
 Decision-making and brain systems

• The human brain has a wide array of functions including functions to help
us interpret sensory inputs, originate and coordinate motor responses,
control basic functions such as sleep, hunger or thirst, stock and retrieve
information required to perform tasks, and guide abstract and complex
decision-making. The cerebral cortex controls higher functions. It is
composed of various systems with specific missions.

• The primary sensory cortices are involved in the treatment of sensory

information. Representations are created from primary sensory inputs.

• The motor cortices (primary and secondary) are responsible for the
planning and execution of voluntary motor functions. They host the
process of action implementation rendering decisions.

17
• The prefrontal cortex is in charge of complex cognitive tasks, expressing
personality, and moderating behavior. The primary activity of the
prefrontal cortex is thought to be cognitive control, that is the
orchestration of thoughts and decisions in accordance with internally
generated goals.

• Uncertainty is relevant in most situations in which humans need to make

decisions and will thus affect the problems to be solved by the brain. For
example, we only have noisy senses, and any information that we sense
must be ambiguous because we only observe incomplete portions of the
world at any given time, or shadows of reality.

18
• Models in Bayesian statistics start with the idea that the nervous system
needs to estimate variables in the world that are relevant (x) based on
observed information (o), typically coming from our senses (e.g. audition,
vision, olfaction). Bayes rule then allows calculating how likely each
potential estimate x is given the observed information o:

• p(x∣o) = p(o∣x)p(x)/p(o)

19
• For example, consider the case of estimating if our cat is hungry
(x=“hungry”) given that it meowed (o=“meow”). If the cat usually meows
if hungry (p(o|x)=90%), is hungry a quarter of the time (p(x)=25%), and
does not meows frequently (p(o)=30%), then it is quite probably hungry
when it meows (p(x|o)=90%×25%/30%=75%). If, on the other hand, the
cat meows quite frequently (p(o)=70%), then the probability of being
hungry if it meowed is much lower (p(x|o)=90%×25%/70%=32%). The
formula above can also be seen as a way of updating the previous belief
on the world, or prior (p(x)) by the current sensory evidence, or likelihood
(p(o/x)).

20
• Models using Bayes rule have been used to explain many results in
perception, action, neural coding, and cognition. Bayesian models that
have been used in these contexts have many different forms. The
differences between these models derive from distinct assumptions about
the variables in the world and the way they relate to one another. Each
model is then the unique consequence of one set of assumptions about
the world. However, all these Bayesian models share the same basic
principle that different pieces of information can be combined in order to
estimate the relevant variables.

21
• In Bayesian networks, there are two kinds of random variables: those that are
observed and those that are not observed. For example, we can hear our cat
meow (observed variable) but we can never directly observe that it is hungry, only
infer that from its behavior. Therefore, hunger is fundamentally an unobserved
variable—unless some new neurophysiologic procedure is invented . Unobserved
variables are called latent or, as we will call it here, hidden. These hidden variables
are typically estimated given the observed variables in Bayesian modeling.

• Bayesian statistics provides a way of calculating how to optimally combine the

cues, i.e. a way of maximally reducing the final uncertainty about the cat’s
position. The resulting estimate combines the cues, weighting them according to
their reliability. If people combined cue information in a Bayesian way, the
resulting estimate has less or equal uncertainty compared to the uncertainty
associated with any of the cues.

22
 Bayesian decision making

• So far we have discussed ways of estimating hidden variables, but that is

only the first step in decision-making systems. In our example, after
estimating the probabilities associated for each potential cat’s location
around the garden, we have to choose how to capture it. Depending on
the way we do that, we may incur in a cost—for example, by stepping on
the cat’s tail. In the field of economics, such costs are generally described
as negative utility; utility measures the subjective value of any possible
situation. Decision theory deals with this problem of choosing the right
action given uncertainty, generally by calculating the action that
maximizes expected utility.

23
• Bayesian decision-making can thus be seen as the important final step in
all the models explained above. The models explained in previous sections
give us potential optimal ways of perceiving the world, but if we then
want to act upon it, we should also take into account the potential
rewards and risks associated with each estimate.

• Sensorimotor research has shown that human subjects, when doing a

movement task, besides being able to estimate their motor uncertainties
This is in contrast to many high-level economics tasks, where human
subjects exhibit a wide range of deviations from optimality.

24
• To maximize expected utility, our brain has to represent not only the
reward or cost value for each action, but also the associated uncertainty.
The neural representation of these variables has been the focus of the
emerging field of neuroeconomics.

• Neuronal activations related to uncertainty in reward (more specifically, to

risk) seem to be segregated spatially and temporally from activations due
to expected reward, with activations due to risk occurring later than the
immediate activations due to expected reward.

• Thus, reward value and risk have been associated with spatially and
temporally distinct neural activations in specific brain areas, suggesting
that the brain can use both sources of information to estimate expected
utility and guide actions.

25
 Summary
• The groundbreaking research of Daniel Kahneman showed that our brain
has two operating systems. Which he called system 1 (Intuitive)and system
2 (Rational)

• System 1 is Fast, unconscious, automatic, effortless, Without self-

awareness or control and makes 98% of all our thinking.

• System 2 is Slow, deliberate and conscious, effortful, controlled mental

process, rational thinking, logical and skeptical, seeks new/missing
information, makes decisions and Makes 2% if all our thinking.

• By understanding Kahneman one can understand human decision-making.

you can understand human or investors’ behaviour, One can see how they
are predictably irrational.

26
• Suggested Readings and References

• https://link.springer.com/content/pdf/10.3758/BF03196730.pdf

• Thinking, Fast and Slow by Daniel Kahneman

https://books.google.co.in/books/about/Thinking_Fast_and_Slow.html?
id=oV1tXT3HigoC&printsec=frontcover&source=kp_read_button&redir_esc
=y#v=onepage&q&f=false

• https://www.ncbi.nlm.nih.gov/pmc/articles/PMC3079291/

27