I expect you’ve heard of the Marshmallow Test. It’s the one where you leave a four-year child alone for a few minutes in a room with a marshmallow on the table, promising further rewards if they can restrain themselves from eating it. After initially trying to hold out for the reward, most four-year-olds find the immediacy of the marshmallow too much to bear. The interesting part of the original Marshmallow Test, carried out in Stanford in the late 1960s, is that the children who gobbled up the marshmallow generally went on to do worse in life according to various measures. Like many psychology experiments, there is a fair amount of controversy around what the Marshmallow Test actually shows. It could demonstrate that an ability to be patient and exercise self-control is a crucial life skill, or alternatively it may be that some other unobserved factors were at play (e.g. socioeconomic background, intelligence, trust). I don’t think it takes a huge leap of faith to believe that patience is an important life-skill. One area where I’m pretty confident that gobbling up marshmallows is likely to cost you is in investing.
It’s fairly uncontroversial that patience and impulse control are essential attributes if you want to be a successful investor. In the words of Buffett: ‘the stock market is a device for transferring money from the impatient to the patient’. Impatience can lead to all sorts of mistakes, such as taking more risk to try to speed up returns, over-trading and selling too soon to resolve unwanted uncertainty, to name a few.
Being patient should be straightforward. All you should need is self-discipline: set yourself rules and stick to them! The issue is really why practicing self-discipline is more difficult than it should be and what can be done about this.
You are not fully in control
Luckily for me I’ve never liked marshmallows. I like to think I have pretty good self-control but like most people I have my weaknesses. One of them is food. I’m obsessed with both eating and cooking it. Put pretty much any savoury food in front of me and I’ll reliably eat too much. Even when it’s not there it affects my decision-making. I obsessively plan meals in advance and often freak out when out for dinner with several people about how to best coordinate the ordering. I had the recent epiphany that all the arguments I can remember started when I was hungry before a meal. More relevant to investing, I am also affected by the urge to gamble. I’m no addict, but put an uncertain reward in front of me for long enough and I’ll feel compelled to have a go whatever the odds, especially if I get hungry.
I’m not exceptional here. It’s much more exceptional to be able to go through life without these sort of impulses affecting your behaviour and leading you to make irrational decisions. This brings to mind the famous study of Israeli judges which found that they were several times less likely to make favourable parole decisions just before they had their lunch than just afterwards. The thrill of gambling can be frighteningly addictive for an unfortunate few with devastating consequences. It seems unlikely that the rest of us would be entirely immune from this thrill. We are all prone to make impulsive decisions from time to time, though to varying degrees.
The reason these impulses can make you behave irrationally is that much of your decision-making is driven by your subconscious. It’s easy to forget this when you face the persistent illusion that your conscious mind is fully in control. In reality your subconscious is constantly putting ideas and incentives in front of you. Your dopamine system uses your memory of previous experiences to reward you for behaviour that has led to success in the past. When faced with uncertainty, your brain releases dopamine in anticipation. ‘Remember how fun this was that previous time’ it says, ‘well here is an opportunity to experience it again but you need to act now’.
This is a great system for learning from experience and reinforcing pattern recognition to spot opportunities and threats. The instincts and intuition it creates can be highly sophisticated and extremely useful. However, the system is imperfect and can bias your decision making in all sorts of ways. For one it’s pretty bad at accounting for probabilities, which are pretty key when rewards are uncertain. It’s also not very patient – it wants success now. Sometimes impulses can be too hard to resist even when you actively perceive them to be irrational. Often you know it would be better to be patient but can’t help yourself from spinning the wheel to see what happens.
How to control your impulses when investing
The first step is to realise the extent to which your decision-making is driven by your subconscious and recognise that this is no bad thing. It’s unhelpful to only see impulsiveness as a character flaw that holds us back from perfect rationality. It’s also the outcome of an important and powerful natural cognitive process. Controlling impulses is as much about retraining your instincts to align with what actually delivers success as it is about simply resisting them and supplanting them with conscious thought.
Defining clear rules and then sticking to them consistently can achieve both of these goals. However, it is much easier said than done. There is not a one-size-fits-all solution for either the best set of rules or the best way to make sure you follow them.
Rules don’t just directly restrain you from making silly mistakes but also frame your perspective: what time period is relevant, which situations require your judgment to make decisions and which require you to sit on your hands. This is important if you want to retrain your dopamine system rather than let it get triggered willy-nilly every time you hear about an opportunity or even just look at your portfolio.
Rules should cover both what to buy and when to trade. It’s relatively straightforward to define a checklist that helps you assess candidate investments. I’ve found it very useful to restrict my ‘investing universe’ to a watchlist of high quality shares. I update my watchlist infrequently and never buy anything I have only just added. Before I did this I was prone to impulsively buy my latest great idea straight away, only to have second thoughts not long after when the initial excitement had settled and more of the downsides had become apparent.
Probably the more important rules are the ones that govern when you trade. Even if you are strict about what you buy, without trading rules it’s easy to lapse into making opportunistic decisions to buy or sell on a whim. In deciding when to trade I use a simple system of periodic rotation to leave no room for ad-hoc judgments about when it might be the right time to take profits on a winner or cut short a loser. I found the temptation to do this too soon was too hard to resist without rules – I would nearly always capitulate in a moment of weakness or boredom.
Rules are much easier to stick to if they are not too complicated and don’t leave too much room for judgment. Some of the simplest strategies can be the best. You’re unlikely to make impulsive trading decisions if your strategy is simply to buy and hold until the story changes. Similarly, it’s important that your rules are consistent over time. Allowing yourself the flexibility to constantly refine your rules makes it harder to resist impulses and harder to train your instincts. This means there is a tricky trade-off between the benefits of refining your approach over time and applying it consistently. I would tend to err on the side of consistency until you are happy your instincts are well-aligned with your strategy. It is always going to be tempting to make too many adjustments, as even well-conceived strategies will go through periods of underperformance. I think the best advice is put in the initial time and effort to find a simple strategy in which you have conviction. Then just stick to it through thick and thin unless you are very confident that an alternative will be better over the long term.
Sticking to the rules
Even the clearest set of rules can go out the window when the impulse to gamble or to realise profits is too great. It can be highly perplexing and frustrating to find yourself breaking your own rules with reckless abandon despite your better judgment. However, looking at decision-making and behaviour more broadly it’s hardly surprising this happens to many of us. Blindly following simple rules in complex situations is not an effective strategy much of the time. If you want to get better at sticking to your rules you need to be patient with yourself. You are not in full control of your decision making and it takes time to change your habits.
The tried and tested system for getting people to stick to rules in the real world is to shout at them and call them names (or worse) when they don’t. This is certainly effective for soldiers and professional athletes, though I haven’t thought of a way to incorporate it into my investing process yet.
A big source of difficulty in sticking to the rules is over-engagement. Checking in with your portfolio’s performance too regularly can make you overly sensitive to short-term price movements. Waiting to see if investment decisions come good should be slow and boring. Most sensible strategies should require you to make decisions infrequently. This means that reviewing your portfolio once a month or even once a year should be sufficient. If this is the case, why check how well your portfolio is doing every day or even hour? I’m sure most investors know that they’d be better off not constantly monitoring their portfolio but many do this anyway (e.g. the daily performance reporting on Twitter). Personally, I find it highly addictive to monitor my portfolio’s value regularly, silently rejoicing when it’s going up and despairing when it’s going down. I know this can’t be healthy for my decision-making but I do it anyway. However, I have found a couple of things have helped a little. First, I’ve come up with plenty of other investing-related tasks to fill the void, like curating my watchlist, doing more detailed research or writing my blog. Second, since moving to periodic rotation I’ve become a bit less engaged with price movements as I know I’m not going to do anything about them until my next trade anyway.
Another aspect that can affect your resilience to short term price movements is your level of ambition. Having conservative expectations for your performance isn’t just about modesty. It’s about making sure you are going to be patient if your portfolio isn’t motoring as quickly as you’d hoped. Having a good year can be double-edged if it raises your expectations too much and makes you less patient.