Psych 101 –
Psychology in Investment
Welcome to Psych 101, my first post about the psychology of trading and investing. My undergraduate degree was in the subject, and I’ve maintained an interest ever since. It has become a more popular area in general with the rise of Behavioural Investing.
I studied a scientific, experimental version of the topic, and so my definition will be wider than the popular model of Freudian pychoanalytics. Basically anything to do with the brain and our perceptual systems is up for grabs.
Over the coming months I hope to put some structure around this part of the website, but for now I will begin with a roundup of psychology flavoured articles I have come across in recent weeks.
The Marshmallow Test
You can buy the book here:2
The test itself is pretty simple: decades ago, Walter Mischel left children alone with a marshmallow for 10 minutes, promising them a second treat if the first one was still there when he returned.
In the years that followed, he noticed a difference between those able to resist temptation and those who could not. Without spoiling the book’s ending, the resisters were more successful – higher test scores, thinner, not addicted to drug and alcohol, better savers.
More interestingly, it didn’t matter whether the winners were Stoics, just able to resist, or whether they used distraction tactics (singing songs, playing the piano with their feet) or visualisation techniques (imagining the future).
Michel refers to these tricks as overriding the “hot” brain with the “cold” brain, which I suspect ties pretty closely to Kahneman’s “fast” and “slow” systems.3 He recommends thinking of yourself in the third person – you need to be the director of the movie, not the hero.
In my own experience, the ability to stay calm and defer gratification is the single most important factor in success. Long-term thinking simplifies everything. I have this in some areas (money) and not in others (food and drink, football, working for idiots). In investing, most of the good habits are well known, it’s applying them month after month that’s difficult.
What I find particularly interesting is the idea that resisting temptation is underpinned by a belief that the promise of the second marshmallow will be kept. Those who prefer the bird in the hand don’t feel this way. For various commonplace reasons, my own childhood leads me to have little faith in people, but I seem to have great faith is science and maths, and in myself. And that seems to be enough.
Character is destiny
He mentions the marshmallow test as leading to the conclusion amongst many educators that traits like self-control should be taught in school.
Young doesn’t agree, because he says character is inherited. Nature not nurture will decide whether you can stick at things, and bounce back from defeat (he references a book by an American psychologist and and a twin study in support of this). Character is evident by the age of 19 months.
What are you actually buying?
In a different issue of the same magazine, Rory Sutherland (vice-chairman of Ogilvy Group UK) looked at the psychology of purchases. He began with the 1980s experiment by Richard Thaler where people imagine they are thirsty on a deserted beach.
A friend will trek over to a distant bar and buy you a beer if the price at the bar is less than the limit that you say you will pay. The point is that when the bar is described as a beach shack, people will pay only $1.50 (80s prices) for a beer, whereas if it is boutique hotel, the “fair” price goes up to $2.65. It’s the same beer, remember – and you’re drinking it on the beach, not in the bar.
Thaler’s explanation is that buying something has two “utilities”: one for the thing itself (the acquisition) and the other for the process of buying it (the transaction). This explains the bad decisions people make in auction rooms and in sales, where the thrill of the purchase compensates for issues with the goods themselves. I think it might also partially explain why paying in cash instead of by credit card can cut your spending.
Sutherland uses this to explain why buying people nice Xmas presents is a good idea, rather than giving cash. Experiences will also be valued more highly than things. It’s only the usual tat that needs to be avoided.
From an investment perspective, I think the lesson is to be wary of online platforms that are too nice to look at and to use, and that come with lots of analytical tools and easily digestible glossy mailshots full of investment ideas (I’m looking at you, Hargreaves Lansdown). A focus on costs and ease of execution might be more appropriate for long-term success.
Losing your marbles
Over in the Telegraph, Katie Morley reported on a Harvard study which found that people’s ability to make good financial decisions peaks at age 53 . That’s me over the hill then.
Basically, “crystallised intelligence” (experience) no longer compensates for the decline in “fluid intelligence” (problem-solving smarts). By age 80, about half of people have significant problems, and shouldn’t be making financial decisions.
Studies in the UK have reported similar results, and the recent review of annuities by the FCA found that 80% of savers (all aged 55-plus) could have got a better deal by shopping around.
The UK government response was confusing: Nest called upon the industry to develop products where all the planning was done while people were still in their 50s, while Ros Altmann, (older workers champion) called the research “ageist”, pointing out that “plenty of people in their 80s … are still very mentally capable” (Warren Buffett, anyone?).
I agree with the idea of making plans whilst in your 50s, and things like annuities make a lot more sense at age 75 than age 55. If you are feeling particularly brave / trusting, you might even grant a friend or relative a lifelong power of attorney over your affairs.
Ideally, people should have a lifelong plan which is regularly updated, like a living will. If you are one of the lucky ones and still compos mentis at 80, stick with the drawdown. If not, plan B can kick in automatically.
How much for the bat?
The poor face particular obstacles: lack of information and education, illiberal societies, blunted aspirations, short-termism. risk aversion (due to the lack of a resources “buffer”). The new behavioural approach focuses on decision making rather than lack of resources.
In Bogota, mothers were paid monthly for school attendance by their children. Withholding part of the payment until the following school year improved re-enrolment rates significantly. A Jamican programme from the 1990s showed mothers of malnourished children how to encourage verbal and physical skills. Twenty years later, these children earned more than comparable well-nourished children.
It would be great to see similar ideas introduced into our own savings, taxation and benefits system. I suppose this is what Cameron had in mind when he set up the famous “nudge” unit, but it all seems to have gone very quiet. Once again, political short-termism trumps the long-term well-being of the nation.
I remember one of the initial suggestions being the removal of the “free at the point of use” pledge for the NHS, since this must inevitably swamp the system with hypochondriacs. Who has the balls to sell that one to the British public?
People don’t like talking about how much money they have. Instead of talking about our wealth, we imply it through physical things like cars and houses and clothes and jewellery that really don’t have that much to do with it.
Over on his Behaviour Gap blog, Carl Richards wondered what life would be like if we made wealth transparent. If we had to walk around with a number flashing above your head, Carl thinks this would be the end of consumerism. Why buy something to represent wealth if everybody already knew what you were worth anyway?
The underlying problem is that value in a modern society (developing a website, or producing a TV programme) is much harder to communicate than being a farmer or a builder. So we buy expensive cars (or trainers, or Apple geegaws) on credit instead, making ourselves poorer in the long-run.
What if people were embarrassed by not having saved for their retirement, rather than by driving a 5-year-old 1-litre hatchback (or even riding the bus)? Would people make more sensible financial choices? Would they spend to please themselves rather than impress others?
We might not be able to implement the flashing lights just yet (though we’re probably just an iWatch app away from this) but we could certainly tack a balance sheet onto the the income statement that we currently submit each year as a tax return.
We already do this for limited companies, and most investors work out their net worth at least once a year. So who wants to go first with that? “After you, Claude.” “No, after you Cecil.”
- I can’t remember where I read it, but I’ve decided to link to the Guardian version as I rarely link to them. [↩]
- this is an affiliate link, and I will be paid a small referral commission if you buy through this link [↩]
- as popularised in the book “Thinking Fast and Slow”, to which we will return in a later post [↩]
- the title comes from the inability of people to allocate costs correctly between a bat and a ball when told they cost £1.10 in total, and the bat is £1 more than the ball [↩]