Sunday, June 08, 2014

Would you pass the marshmallow test?

In the early 1970's Stanford University conducted a series of psychological tests on young children. The results of these experiments helped shape how people thought about success, motivation and drive in individuals. Arguably the most famous of these experiments involved some marshmallows.

The test was basically this: a group of four year-old children were placed in a room and were each given a single marshmallow. They were then offered a choice: eat the single marshmallow now, or wait 15 minutes and receive an extra marshmallow as a reward.

The results showed that children who took the single marshmallow exhibited what is known as the urge for instant gratification. Those who waited for the additional reward of an extra marshmallow displayed delayed gratification.

There was a follow up to these tests some years later. The same children were interviewed and there was found to be a close correlation between the results of the original tests and their personalities in later life. Basically, those who wanted instant gratification displayed traits such as impulsiveness, pessimism, envy, anger and indecision. Those who had been able to delay gratification were more likely to be optimistic, confident, have clear goals, and be competent and self-reliant.

So, what has this to do with trading, and trend following in particular?

Well, think of the basic tenet of such an approach - to cut losses short and let profits run. Most traders I know have little difficulty in taking losses. The principles of preserving capital and avoiding big losses have been drummed into them enough. The difficult part comes with letting profits run.

Emotions such as fear of losing existing profits can come to the fore, resulting in profits being cut short. Done enough, then this becomes a self sabotage issue. Those traders are satisfying an internal demand for instant gratification. Those who are happy to let their profits run, and let the trends play themselves out, have delayed gratification.

For trend following to work, you have to get the occasional big winner to offset against all the small losers and the low win rate. To do this, you therefore have to avoid the urge for instant gratification. The plan should be to let profits run until the trend has been extinguished, not to make an impulsive decision on a minor price reaction for fear of losing those profits.

Now, think back to your childhood. If you were taking part in the marshmallow test, how do you believe you would have responded?

Traders who suffer from self sabotage, particularly when it comes to this issue of letting profits run, may find this thought provoking. The personality traits that lead to this behaviour are generally formed by choices made or beliefs held, often years or maybe even decades before. The good news is that, you now may be able formulate a plan to work on addressing these issues. It takes willpower, and a change in your beliefs or choices. But, as we know, these can be changed.

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