Just bear with us on this one – we promise we’ve not cracked open the mulled wine too early!
There’s actually a lot that investors and stock market traders can learn from psychology. From market confidence to herd mentality, as much as many investors would want you to believe it all comes down to rationalism and hard maths algorithms, there’s often a huge dollop of simple human psychology at play.
So, here’s our take on what the Stanford marshmallow experiment can teach us about investing. It’s a little journey into the concept of delayed gratification, and how we can use this psychological trick to encourage ourselves to take a longer term approach to our investing.
What is the Stanford marshmallow experiment?
The Stanford marshmallow experiment was a psychological study carried out at Stanford University in 1972. You can read the full details here, but basically, the study attempted to look at the effect of self-control and willpower in children.
The researchers would tell children that they could either have one marshmallow (or other tasty snack) now, or if they waited for a set period of time, they’d get two. This experiment has been replicated in small, non-academic versions countless times, with similar results – children often struggle to wait for the better reward as their self-control battles with their desire for a sugary treat.
Obviously, adults may find it easier to resist the draws of a marshmallow – especially if the promise of several more is used as a reward. Many of us even use versions of this experiment as a motivational tool, such as saving snacks until after we’ve finished writing articles for our blog!
The point of the study and others like it is that the ability to delay gratification is an important part of becoming a successful adult. So, what can this teach us about investing, and how to successfully negotiate the stock market and grow portfolios?
How do we apply the Stanford marshmallow experiment to investing?
Well, let’s look at a quick example. We’ve chosen Tesco PLC – where you may be heading to shortly to pick up a nice Christmas turkey!
If you’d bought shares in Tesco on the 27th November 2015 as part of your investment portfolio, and then sold them around 6 months later on the 29th April 2016, you would have made a tidy return of 1.74%. Not bad if you’re looking to flip shares for a quick profit – if you wanted your marshmallow right now.
But, if you’d kept these shares for 5 years, and held them until the 27th November 2020, you would see a return on those shares of 35.26%! A massive increase on the 1.74% you could have had. In short, by waiting – you’re getting a lot more marshmallows!
Now, this won’t always be true. Some share prices are trending downwards over time and holding them is a bad idea for your portfolio. And sometimes, there’s quick money to be made by flipping shares right before a company’s share price takes a big hit. But it’s not easy to predict when this will be.
The other thing to bear in mind here is the concept of asymmetric trades. What this means is making investment decisions where you expose yourself to as much reward (profit) as possible, while limiting your risk. Buying shares in a company is an example of an asymmetric trade, because your risk is only the amount you invested – but the potential upside could be many times your original investment as the company grows over years and years. By holding the shares longer term, you expose yourself to more opportunities for reward, while keeping your risk (limited to the original investment) the same. Just like marshmallows (well, sort of).
Part of the trick here, of course, is identifying which companies are set for big growth over time, and which might be headed all the way to zero. That’s where professional investment planners come in. At Face to Face Finance, we’re experts in helping our clients make the right investment choices. We don’t believe in gambling on short term performance, so if you’re looking for a long-term portfolio where your adviser takes the time to get to know your goals, speak to Face to Face. We may even offer you a marshmallow!
All return figures quoted here do not factor in any investment or plan charges and remember that past performance should not be used as an indication of future performance. Your investment capital is always at risk.