Risk Aversion, Discipline & Marshmallow Experiments
There are two areas of academic research I have long found fascinating — Behavioral Economics, and Cognitive Psychology.
For investors, Behavioral Economics looks primarily at rationality: How rational or irrational are investors in what they do — their behavior, decision making, investing, etc. Cognitive Psychology, on the other hand, is concerned with our wetware — how we process information, what foibles inadequacies, and are prone to errors. The focus is our internal mental dynamics. Combine the two, and we end up with something like NeuroEconomics.
Which is what I was thinking about when I read this New Yorker piece on the ability of children to delay gratification as a marker of subsequent success.
The article refers to an experiment: Kids are offered a marshmallow — and then offered a deal: They could eat one marshmallow right away or, if willing to wait a few minutes, they could have two marshmallows. The results are quite surprising.
But it got me wondering: How much of what is described as risk aversion is merely another form of behavioral or cognitive issues — like self-discipline of gratification delay?
Food for thought . . .
>
Source:
DON’T! The secret of self-control.
Jonah Lehrer
New Yorker, MAY 18, 2009
http://www.newyorker.com/reporting/2009/05/18/090518fa_fact_lehrer
See also:
Mischel’s Marshmallows
Podcast
Radiolab, March 9, 2009
http://blogs.wnyc.org/radiolab/2009/03/09/mischel’s-marshmallows/
June 20th, 2009 at 3:46 pm
BR,
nice post, though, it may be easier to deal with if you offered/sketched out a definition for what passes as “risk aversion”..
btw, how did ‘Book Revue’ treat you? ~
June 20th, 2009 at 4:56 pm
More interesting applied uses of Behavioral finance Jason Zweig…
http://online.wsj.com/article/SB124545477468032915.html?mod=googlenews_wsj
…regarding our Commander in Chief’s declaration to use science to create policy, unlike his predecessor’s “no-nation building” belief… Oh, and more nation building going on too…
http://online.wsj.com/article/SB124545705106832957.html?mod=googlenews_wsj
It’ll be interesting to see how the lobbyists try to go after this. How proud those lobbyists parents must be.
June 20th, 2009 at 5:15 pm
BR-
then you must be a fan of Dr. Alexander Elder
June 20th, 2009 at 5:28 pm
My bet is the kid who opened the oreo, licked out the filling, and replaced it works on Wall Street now.
I last read it decades ago, but I recall B.F. Skinner described something quite like the marshmallow test in his utopian novel Walden Two, training children in self-control using lollipops hanging around the neck. It was a very underappreciated work.
June 20th, 2009 at 6:14 pm
The video version from ted.com is here.
June 20th, 2009 at 6:53 pm
The lesson living in America is that if you are offered a marshmallow, MOST will eat it right away…
but there are those who wait patiently, and don’t eat a marshmallow (waiting for TWO)…
In the end, they never actually even get to eat the one marshmallow…
Instead, their government confiscates it and hands it over to the less disciplined ones as a bailout…
June 20th, 2009 at 6:55 pm
cvienne-
pretty funny- and true
June 20th, 2009 at 7:25 pm
@ahab
Re: “pretty funny- and true”
WAIT – there’s more…Then since the half of the population overindulged in TWO sweets, they all have cavities, and become diabetic…
So then the government has to come up with a universal healthcare package to take care of all the sickness and poor dental hygeine…
June 20th, 2009 at 7:30 pm
…and in the future, there will NO LONGER BE marshmallows because all the corn used to make ‘corn sweetners’ will be used to fill up gas tanks instead…
June 20th, 2009 at 7:42 pm
BR, yea but….if the guy telling you that you can have a second marshmallow is wearing a pinky ring and a shiny suit then self discipline in that case is a form or risk analysis. right? Or even more basic…if you’re a predator and you wait & hunt: Do you grab the first thing that comes along or do you wait and risk the appetizer being gone later? Emotions are evolution’s computer code for these reactions.
June 20th, 2009 at 8:28 pm
DM RTA-
interesting points
June 20th, 2009 at 8:50 pm
If offered a marshmallow most would ask for the graham cracker, chocolate and an open fire to make s’mores.
June 20th, 2009 at 8:52 pm
> all the corn used to make ‘corn sweetners’ will be used to fill up gas tanks instead…
Probably a good thing. Those radical “corn sweeteners” have been brutal to our diet.
Give me conservative, old-fashioned sugar anytime.
June 20th, 2009 at 9:38 pm
In the context of investing the idea of gratification delay leading to more gains or pleasure later has currents running against one and other. Greedy demand for instant gratification could result in lower gains. Equally greedily holding a winning position in hope of further gains could result in losses. Oddly the more delay an invester will accept in the investing world the worse their returns could be.
It could be that the investor having sucessfully accrued funds to invest with, who has thereby demonstrated his ability to delay gratification, who then accepts further delay by investing those funds for further gain, is poorly adapted for the investment world.
The contrarian recognizing this inate dissonance understands that what worked for the majority before they started investing can be used against the majority after they start. The majority will wait for a clear trend do develop once they are confident in it they will invest. Having learned to be patient they will be biased towards the longer time frame. The contrarian will try to be early and will then look for the point in time when all the new money has arrived before he sells. He will correctly identify that point in time as when there is heightened optimism or maximum bullishness in the general population of people who could invest.
The super investor will try to second guess the market by understanding that the market movers are at different times more or less sophisticated. In a bear market rally it could be that there are very few NEW participants and the reversal time or bullish peak may be far more difficult to pick.
Barry may be thinking here that there is insufficient new money in the market to allow the experienced investors to cash out with winning hands. Hence the possibility of a longer delay and further pumping to pull in the inexperienced Johney come latelies before the inevitable dump.
Disclaimer. If I sound like I know what I’m talking about it is a complete coincidence.
June 21st, 2009 at 12:00 am
Brings to mind a classic from The Onion:
Report: Economically Disadvantaged Men More Skilled At Communicating Attraction To Women
http://www.theonion.com/content/node/28017
June 21st, 2009 at 6:31 am
For Older Investors, Old Rules May Not Apply
“But some people are no longer comfortable with that logic. There’s even a new study that contends holding stocks over long periods of time may be riskier than previously thought. Robert F. Stambaugh, a finance professor at the Wharton School at the University of Pennsylvania and a co-author of the report, said most investment research only accounted for the risk of short-term market swings around the stock market’s average gain over time. It doesn’t factor in the fact, he said, that the average itself is subject to change. ”
“If another decline in the market is going to bankrupt you or put you out of business or destroy your retirement account, you should not go back into the stock market,” said John C. Bogle, the founder of Vanguard and viewed by many as the father of index investing. “It’s not complicated. The stock market can go up and down a lot and nobody really knows how much and when.”
June 21st, 2009 at 8:23 am
Continental AG to Delay Paychecks to Meet Loan Terms
June 19 (Bloomberg) — Continental AG, Europe’s second- largest car-parts maker, said it will delay June paychecks by “a few days” to ensure that it meets loan commitments.
I believe they are trying this novel method in California, from the state to the taxpayer…
June 21st, 2009 at 9:02 am
In the end, they never actually even get to eat the one marshmallow…
Instead, their government confiscates it and hands it over to the less disciplined ones as a bailout…
—————-
Funny comment. But that would mean that impulse control is innate and can not be learned.
If there were never any benefits to waiting, a person would soon stop waiting.
June 21st, 2009 at 9:25 am
It’s a fine line between self control and pragmatism.
Too much self control and you’re dogmatic and a control freak. Not enough and you’re all over the place.
My big thing in University was to mentally calculate how much time I would need to invest for an A vs. the A+. It usually followed the 80/20 rule. Then I would evaluate how importnat that A+ was in the grand scheme of things. Since I had many interests, it would essentially be the maximizing of a Lagrange equation!
Some people exercise incredible self-control as a risk control mechanism, others as a way to maximize their utility out of life.
June 21st, 2009 at 10:36 pm
cognitive psychology is not, at least not exclusively, about how people “process information”. the whole computer metaphor for cognition became ascendant in the 1980’s, and while it has a variety of serious difficulties (for one, memory is not at all a type of storage, but a type of reconstruction; for another, it has so far been impossible to program a natural language function; for another, the contributions of emotion, mood and fatigue are undefined); those have been left aside to pursue avenues that the metaphor can clarify: almost all of them quantitative and perceptual (especially robotic vision) in application.
risk aversion is a “trait” that appears and has been successfully bred in mice; it’s a long and wide research tradition in personality psychology, and it appears negatively related to the “traits” of sensation seeking and extraversion. despite some interesting work in the late 1990’s there has not been much consolidation of the field of personality psychology around “computational” metaphors.
to the question: yes, risk aversion, however you choose to measure it, appears as a dimension of individual behavioral difference across many biological species; it can be bred (inherited) but also is related to many aspects of individual experience (for example, the nurturing style of an infant’s caregiver), it affects learning and decision making, and it appears to have a neurological basis, like everything else we do.