A claw game machine, emotions, a bit about the lottery, and how it all relates to the investment world.
I believe most of us have tried our luck with a claw game machine. Yeah, you know, the one with the claw descending at a push of a button, trying to grab different prizes ranging from plush toys to electronic devices.
Now imagine you are the player. You are probably aware that the most expensive prizes are strategically placed, so that it is harder to pick them out. Although the odds are NOT in your favor, you insert a token into the machine to activate and manipulate the joystick that controls the claw. You are “locked in” on your target. You adjust the claw to be placed just above it. You push the red button. The claw lowers itself on the target. You are already imagining the prize is yours for the taking! It will be in your hands at any second now and all that it would take is that single “symbolic” token needed to try your luck! AND HERE, IT HAPPENS!! The claw has grabbed on to the target. The crane has lifted it up. It is making its way to the door so that you can finally claim it! “PLEASE DON’T FALL, PLEASE DON’T FALL,” you are muttering to yourself with a slight “fear”. That’s it!!! A smile comes to your face. Your adrenaline is at an all-time high. You have managed to beat the machine! And suddenly… the claw releases its hold on the target, dropping it just before the finish line. AND THE GAME IS OVER. The machine kept the prize to itself… and your money too! At this point, you are more determined than ever to beat the machine and win.
The sense of missing out gives you the hope that a win is just around the corner. You have already “wasted” one token. All you have to do is “invest” just one more token to collect your coveted prize. It is supposed to be easy! STOP. Think about that for a moment. Suppose you have estimated the cost of the prize, as if you bought it in a store. Would you continue playing the machine when you “breakeven”, knowing that the money you put in — your “Total Investment” — is already equal to the cost of the prize in the store? Will you be ready to submit to the sense of loss and overcome the fear of it? If you eventually get the prize — would you be considered greedy if you continue putting in more tokens into the machine until you win again, even at the risk of not being in a price balance?
At this point, you might be asking yourself, how are claw game machines and investments related?! While claw games are perceived as pure amusement, investments are seen as decisions that require serious, rational, and emotionless examination and evaluation. While A claw game player goal is to have fun and occasionally win, an investor’s goal is to achieve optimal returns and minimize losses as much as possible. By now you probably already get the difference between the two, right? Well guess again. In the last two decades, researches and practices have shown that psychology has a significant role in making investment decisions. Many studies have concluded that most of our decisions in the field of investment are irrational. The decisions we make are not always consistent and are not based on a mathematical algorithm similar to the irrational decisions we take upon playing the claw game.
The argument goes that when exposed to uncertainty and complex mental processes, we have a tendency to base our decisions on emotions. In these situations, we work on a systematic trend that makes us deviate from rational decision-making processes, better known as, psychological bias. In the state of psychological bias, the thick line that differentiates between ‘risk aversion’ and ‘risk lover’ becomes blurred — a lack of symmetry is created between the love of profiting and the hate of losing (e.g. a tendency to over-weigh a loss of $1,000 over a profit of $1,000).
In Investment/Trading, psychological bias can be categorized into three emotional (physiological) states that lead to a state of asymmetry:
Fear
For most of us, there tends to be a sense of fear that accompanies us throughout the investment process. It is expressed before entering the investment, when the market goes against us, when we are at a loss, when a profit becomes a loss, or when we are forced to realize a loss. This feeling of fear intensifies when we are exposed to highly volatile markets, like the crypto markets or the commodity markets, where there are constant and rapid changes in our portfolio and P&L (Profit and Loss). Fear is rooted in our awareness of the risk and the uncertainty we face.
Hope
The most irrational emotional state of the three is hope. The feeling of hope can be present after every decision we make but it can be overbearing when an investment does not progress as we had hoped for. For example, in a losing trade, we will be hoping for the market to turn around before we lose all of our money. Hope will encourage us to believe in the unbelievable, to assume that everyone is wrong and that we are right. And that what we want to happen, will indeed happen, even though there is no rational support for it. Hope is the difference between the ‘risk and uncertainty potential’ and the ‘chance and opportunity potential’, making it an extremely lethal source of energy.
A veteran trader once taught me the difference between a trader and a gambler. When we play the lottery, we are focused on the big prize, not the price of the ticket we pay for. We come across commercials about the upcoming lottery or perhaps even a record lottery prize, and we are hopeful of winning the grand prize. This hope makes the sense of loss, resulting from the ticket price, disappear. Here we are, in fact, GAMBLERS! As a TRADER, it is always worth thinking about the significance of a loss before taking the decision to enter a deal, irrespective of how big or small the investment is!
Greed
A feeling that stems from the desire to “jump on the bandwagon” is greed, an inevitable feeling that is usually responsible for the biggest investment mistakes. Greed is what will make us buy at a high price right before the market goes down. Greed is also the emotional state that will prevent us from minimizing risk and increasing opportunity; moreover, greed is the emotional state that will hurt our portfolio diversification in the long run (i.e. overweighing the portfolio with investments that are losing rather than earning). It is THIS emotional state that makes us fear missing out (known as FOMO) from something that everyone around us is benefiting from. We want in, NOW and FAST! The energy source of greed is the ‘chance and opportunity’ component that the investment world offers us.
Trying to win in the claw game machine or participating in a lottery involves feelings of fear, hope, and greed, regardless of the number of games you play, or the level of these emotions. The hope of winning the coveted prize will motivate you to give more probable weight to things beyond your control. If you win once, the greed will motivate you to try your luck again and again, believing that success in the past will guarantee continued success in the future. Once you have played and probably lost, the fear of realizing the loss and admitting in your failure will make you try over and over again. In the financial world, although psychological bias is natural, IT IS UNPROFESSIONAL AND UNPROFITABLE!
So, the next time you make an investment decision… REMEMBER! THE MARKET IS STRONGER THAN OUR DESIRES. Fear, hope and greed are natural human emotional states, and they will, inevitably, affect us in situations of chance, risk, and uncertainty. Although these emotions are unavoidable, they are important for proper and informed investments. The problem arises when they “take over the wheel” and act as a guiding hand in our investment decisions. Loss in trading and investments in the financial world is largely due to psychological bias, a reflection of the change in the rationalization process that occurs in these emotional states. This is exactly what happens to many investors, including professionals. BUT, not to worry! There are certain measures you can take to alleviate the damage caused by psychological bias!
So how do we overcome our emotions and succeed in the investment world? The optimal option is to develop an automated trading machine (a bot) that buys and sells an asset, based on a very clear and independent algorithm, eliminating human emotions all together (how we do this is a topic for another blog)!! Another option is discipline, discipline, discipline! In other words, as an investor/trader you are required to have a lot of knowledge, perseverance, experience, and most importantly self-discipline! After considering an investment and comparing it to existing alternatives, it is crucial to calculate how much you are willing to lose and whether the expected profit justifies the size of the loss. Have a clear strategy — when to enter a trade and when to exit, and what is the size of your trade (i.e. the investment). As tempting as it is to do otherwise, you must ‘STICK TO THE PROGRAM’ that you created for yourself!! While you probably cannot avoid the feelings we have talked about, you can be aware of them and try to minimize their impact. Finally, but no less important, gaining constant knowledge will surely contribute to your experience and your success.
