Imagine an psychological experiment that required participants to sit in front of a computer screen. Four decks of cards were shown on the screen. Within each deck were reward cards and penalty cards. Participants were given a sum of money and told to increase their capital by picking cards randomly from the decks. A reward card would see them receiving a payoff while a penalty card loses them money.
Participants had expected good and bad cards to be distributed randomly among all four decks. Unfortunately for them, the decks are rigged. Two of the decks had a higher ratio of reward cards and someone who constantly selected from these two ‘Good’ stacks would be rewarded more often. The other two decks were more punitive. A participant who selected from these would be punished with losses more often.
Initial selections were haphazard. Participants had no basis to ground their selections on so they picked cards randomly from any of the four decks. It took them a while before realising that certain decks were more profitable than the others. On the average, people had to draw fifty cards before they subconsciously identified which decks were the better ones. It took them another thirty draws before they could verbalise why they picked from these decks.
The Iowa Gambling Task
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The experimenters were led by Antonine Bechara from the University of Iowa. They were interested in something more than the random card picking abilities. They had the gamblers hooked up to a machine that measured electrical conductance of their skin, also known as Galvanised Skin Response. When we are anxious our sweat glands go into overtime. This produces moisture which then allows a small electrical current to pass through. By measuring this current, scientists are able to measure our level of arousal.
They discovered that as early as the 10th card, participants started to record a higher level of anxiety whenever they contemplated drawing from the negative decks. Something felt wrong, and that showed up as a little blip in the machine used to measure current. Even though they were unaware of it, deep in their subconscious, the participants had already figured out the game at a very early stage. They had already known which of their decisions were going to go bad.
‘Sometimes you just know’
Two weeks ago during our coaching session for Value Investors Club members, one of the graduates James and myself were chatting in the back of the room during the break. We were discussing about some of the CNAV stocks he has bought, and how some of them are showing good gains. James commented that while he was unable to buy all the good stocks in the database, he had bought quite a few.
We went further into stock selection, and he said that while most stocks looked equally attractive, there were some stocks where you just ‘had to buy’. His words to that effect were ‘sometimes you just know’.
I went away that evening fascinated about James’ decision making process.
The Decision Making Process
As investors our role is to make decisions. Some of our decisions have huge consequences, for example how much capital shall we allocate to each particular asset class, or whether we should invest majority of our portfolio when an extremely promising stock comes into the picture. Other decisions may not be as crucial; which broker should we trade with, what financial sites to follow and what news to take in. Often our decisions involve a time factor; is this a good time to buy, given that the market has already run up, or is this a good time to sell and cut losses, given that the market is on a free fall.
If we are able to constantly make good, sound decisions there is no doubt that we will find success in the financial markets. Yet hardly any thought goes into thinking about how we ourselves as investors make decisions. Are we rational creatures who follow the laws of logic to the letter? Do we let our emotions run amok? Are there differences in decision making styles between new and experienced investors or even between different personality type?
Or do we, like participants in the Iowa Gambling Task (and James) actually ‘know’ when we are making a good versus a bad decision?
The role of decision making for investors is largely unexplored. Do you know of any avenues out there that could show me the path towards better investing decisions? Leave a comment below or drop me an email to share if you do.
Until then, my fascination continues.