I wrote about Skinner’s Rat some months back. We discussed it during our recent Value Investing Mastery Classes and here is a follow up to explain why it is so difficult to remain invested for the long run.
In a cage there are some rats. The cage has a lever that the rats can press. The experimenters want rats to learn the lever pressing behaviour, and to do that they have programmed food as reward for the rats.
For some cages, the food is dispersed at a fixed ratio. Every press of the lever brings about a pallet of food. The rats learn it quickly, and they like it very much. Every time they are hungry they would go for lever and they will be rewarded with food. The lever pressing behaviour is reinforced and learned.
In other cages, the food is dispersed at a variable ratio schedule. Sometimes the rats would get their food after one press, sometimes two, and sometimes even three or more. The number of presses required is random. Rats in these cages learn that when they need food, they will press the lever quickly and successively until food becomes available.
[Free Ebook] How should you invest your first $20,000?
We asked 14 Singapore finance bloggers to share what they would do if they could go back in time and invest their first $20,000. They can no longer rewind time, but you can learn from their experience and hopefully start with a better footing.
There will be cages where as long as there is a lever press occasionally, food is dispersed at fixed intervals of every three hours. Over time the rats come to realise that it is not about how hard they work the lever but how much time that has passed that will determine the food they receive. They learn to press minimally and spend their time patiently waiting.
And finally there are cages whereby food is dispersed at a variable interval. These rats are the most confused bunch. It is most difficult to get rats to learn lever pressing when they receive variable interval reinforcement.
Rats and Work.
Now try to draw a parallel with the work we do.
Employees who are paid on a project basis like designers and architects operate on the fixed ratio principle. The more work they take on the more they get paid. It is a good system and many people choose to be rewarded in this manner.
There are also many people who are paid on a fixed interval basis. Simply by showing up, they get paid a salary monthly.
Sales people whose remuneration relies on them closing deals are variable ratio rats. They do not know how many prospects they need to meet before coming across one who agrees to buy their product. It could be one, two or ten. But they are aware that the moment they stop working (pressing the lever), they would no longer be paid.
These principles are just as applicable to value investing.
Investors want to consistently buy good stocks at cheap prices. They are constantly on the lookout for value to purchase. When they decide to buy a stock, like the rats, they are actually doing ‘work’ and pressing the lever.
Can an investor make money on every single stock he buys? Unfortunately not. That would be too easy. Hence, it is easy to see that investors are not rewarded on a fixed ratio schedule.
Does it mean that the more stocks an investor buys (more lever presses), the more reward (food) he would receive? Can an investor buy more and more stocks until he gets his rewards? We wish, but we all know that is not the case. Life would be too simple. Hence, investing gains do not operate on a variable ratio schedule as well.
The closest form of fixed interval schedule reinforcement we can get is by investing for dividend yield. Using a yield strategy, investors are assured of constant payouts over time. They have something to look forward to regularly. Dividends may or may not be substantial but the effect on the psyche of an investor is tremendous. It encourages us to remain in the game.
Finally, most forms of investing operate on a variable schedule of reinforcement. We buy a stock but we do not know when it will increase in price. It could be tomorrow, or a month later, or sometimes it could take years. Investors end up confused and many lose faith. They sell before they realise the gains, or they stop buying even when they come across solid stocks. Some even sign off investing totally.
Our Investing Psychology
We all know that to be profitable and successful in the stock market, we need to exhibit consistent investing behaviour. Yet, the variable and random nature of investment rewards does nothing to help us maintain that. We get discouraged and put off when the rewards take too long to come.
Human beings are built to crave certainty and eschew the unknown. Investing requires us to venture into the unknown. We crave order and schedule, but the markets requires us to forgo that for randomness in order to obtain profits.
Investing success is not about how many times we press the lever. It is about how much faith we have and how long we can stay in the game. Understanding this principle will make all of us better investors!