Chapter 9

Dangerous rewards (random reinforcement)

Nicole had never been to the races before, so she jumped at the invitation to go with some friends. None of them knew anything about horse racing or gambling. Nicole decided to bet on a horse in the first race because she liked its name. She won 10 times her stake.

On the second race Nicole randomly picked another horse whose name she liked, but it finished way back in the field. On the third race, she did the same again and won six times her stake. Then she noticed that the two winners had names starting with P, but the loser’s names started with M.

In the next race she picked another horse whose name started with P and it won, giving her seven times her stake. Nicole realised she was onto something. There were no horses in the fifth or sixth races starting with P, so she did not bet. In the last race, she again found a horse starting with P and backed it. It finished narrowly fourth after being hemmed in on the rails. Nicole now knew she was onto something big. That last race was just unlucky — her horse was meant to win.

Over the following weeks and months, Nicole became a punter, always backing horses with names starting with P. Sometimes she won and sometimes they were unlucky again. Nicole had become a victim of random reinforcement. She now had a gambling addiction and a superstition — that horses starting with P win lots of races.

It is early in 2007 and Nigel had never owned a stock in his life. However, his friends seemed to be making so much money that he decided to give it a try. A friend told him mining stocks were where the action was, so Nigel bought some of the same mining stock that his friend had just bought. The stock went up almost overnight. In two weeks the price of the stock was up 50 per cent. Nigel sold them and used the proceeds to take his girlfriend away on an expensive weekend interstate.

Nigel then bought another mining stock suggested by his friend. He did not notice that the one they had sold kept on going higher. The new stock went up for a while, but then fell to near the purchase price. Nigel consulted his friend, who assured him this often happened, but they always went up again. The stock fell a bit more, but sure enough, it then rose and Nigel made another good profit in only a few weeks.

This pattern continued through most of 2007. Several times Nigel’s mining stocks fell below their purchase price, occasionally by quite a bit, but somehow they always came good, or he was able to scramble out about even. Then, late in 2007, Nigel applied for shares in an exciting new mining float. He had to beg his broker to give them to him and had got his girlfriend, mother and brother to also apply with Nigel’s money, so he could get even more.

By early in 2008, the global financial crisis began to unfold and the stock market fell. Mining stocks seemed immune because of the new paradigm thinking that China would keep growing forever and that what was happening in western financial markets would not affect it. Nigel’s stock came onto the market 30 per cent below the price he had paid. Although shaken, Nigel reasoned that they had always come good before, so he would hang on. They went down to further and further. Nigel froze; this had never happened before. Eventually, he could stand it no longer and sold the stock for only 22 per cent of what he had paid for it. He was lucky that he had not taken out a margin loan to buy the stock, or he may have been bankrupt.

Nigel had also been a victim of random reinforcement. Unwittingly, he had broken the classic rules of trading, which are to let your profits run and cut losses short. Nigel had been rewarded often enough, when he held on to losing trades, to teach him that breaking these rules was alright. He also believed in a superstition, driven by the mistaken belief that China would be ‘stronger for longer’, that mining stocks only ever go up in price.

Random reinforcement occurs when someone is rewarded unpredictably, by chance or randomly. The person expects a payoff for their actions, but never knows on which occasions it will occur.

Researchers have done many experiments in this area with animals, famously monkeys and pigeons. Monkeys were trained to perform an action and were rewarded every time they performed it. The monkeys naturally continued performing the action. Then, when the experimenters stopped rewarding the monkeys for performing the action, it was not long before the monkeys stopped.

However, another group of monkeys were randomly rewarded for performing the same action. When the experimenters then stopped rewarding the monkeys, the monkeys nevertheless continued to perform the action for a long time. They had been trained that they would be rewarded, but never knew when the reward would come, so they kept trying. Pigeons behaved the same way in similar experiments. This is random reinforcement at work. It also explains Nicole’s and Nigel’s behaviour.

We now know that random reinforcement is the basis for the gambling addiction, superstitious beliefs and much more. It is very prevalent in the continuing destructive behaviour of investors and especially traders.

In investment and trading, random reinforcement is part of the nature of the activity. It is impossible to get rid of it. Instead, successful investors and traders learn how to deal with it. You have taken the first step in reading this chapter, because becoming aware of the way random reinforcement shapes our decisions is the first stage in dealing with it. Indeed in experiments with humans, it has been shown that a group subjected to random reinforcement, but told about it beforehand, performed tasks better than a group who were simply exposed to random reinforcement, in ignorance of the idea.

Summary

Random reinforcement occurs when someone is rewarded unpredictably, by chance or randomly. The person expects a payoff for their actions, but never knows on which occasions it will occur. Random reinforcement lies behind the gambling addiction and many superstitions. It is also part of the nature of investing. Knowing about it is the first step to avoiding it.

Strategies

1 We start by learning useful behaviours in investment or trading, which we want to foster. In doing so, we need to recognise destructive behaviours, so we can identify better behaviours to put in their place. Many of these destructive behaviours are based on the cognitive biases described in this book. Each chapter has strategies for avoiding the cognitive biases.

2 We need an investing or trading plan that is firmly based on useful behaviours. For a model of what should be in an investment plan, see my book Building Wealth in the Stock Market (Wiley, 2009). We will have tested the plan so that we truly believe it will work if we persist with it. There is no single right approach. There are many ways to make money in the markets. Even more importantly, each one of us is different in many ways. We have to feel comfortable with the various elements that are in our plan. If not, we will be unable to follow it. Finally, we need to execute all the rules and guidelines that make up our plan with as much discipline as we can muster.

We should have some procedure whereby we must monitor our actions against our plan. We must also assess honestly how faithfully we followed our plan. Some people like to devise some reward for themselves for when they follow their plan.

3 I have found it a valuable discipline to write a journal for every investment that I make. In it I record what I know at the time I make a decision to buy. Then, as I manage the investment, I record my reasoning behind each decision. When I close out an investment, I assess it against my investment plan and identify anything I find that I need to work on doing better in future.

I publish my journals in real time (to avoid hindsight bias) on my members’ website and I also publish my annual returns on my free website. This is a superb discipline for me, because my members soon pick me up when I do something outside of my plan and I discuss it with them. I do not expect any readers of this book to do this. Showing our journal to a trusted person is confronting for most people, but could be of enormous benefit in learning to be a better investor. That said, such confidants are few and far between. The important and achievable step is to keep a journal of all investments, recording things as we go along.