Like a trader part 3: Complexity as a cause of commitment

I would posit that most people with the slightest interest in trading have a knowledge of common psychological biases that affect traders, such as confirmation bias.

Confirmation bias appears to influence a further common mistake, being wedded to one's positions. In other words, not getting out when the facts that got them in change.

Such mistakes leave people exposed in other situations too. In Influence, psychologist Robert Cialdini discusses a tactic used by unscrupulous used-car dealers which he calls lowballing.

This means offering customers a car at a price substantially below market value, but without the intention to ever actually honour it. The price is to get them to commit to purchasing from that dealership. 

Then the dealers simply let time and confirmation bias do the rest of the work.

They may get the customers to do lots of paperwork, or give them the car for a test period. It doesn't matter. All they need is time for the customers to think up plenty of other reasons to support their original decision.

When the customer returns to complete the purchase, the dealers will say they (or their boss or the bank) made a mistake, and the car actually costs more. 

The customers, by this time having thought of lots of other reasons to support their decision, more often than not go through with the purchase, despite the original reason they wanted the car from that dealership (the great price) being withdrawn.

Good traders are aware that confirmation bias does not end once they've finished researching and call their broker to make a purchase. If anything, it probably warrants extra caution after they've commited to the position.

However, commitment and confirmation biases are elementary and appear in lots of trading literature, although their interplay is not-so-commonly discussed. 

Something that is less discussed still are a couple of other psychological biases which I speculate are also powerful contributors to poor traders' unwillingness to get rid of bad positions.

The first of these is a marketing point I picked up from a Rory Sutherland podcast. I have not come across it in any purely psychological literature, but it seems plausible.

It is the idea that complexity makes us trust solutions more. Rory's example is stripey toothpaste, which obviously gets mixed up in your mouth anyway and is more difficult to put into the tube.

So why do toothpaste companies go through the trouble? He thinks there is a kind of placebo effect to the added complexity. There are other reasons too but this is the only relevant one to my theory here.

The point is, our bias towards complex solutions may carry over into trading and investment. 

Taken alone, complex strategies could be good or bad. I think sticking to a plan that covers entry, exit and position sizing gives people a better shot at success, and if some find it easier to stick to such a plan with a complex strategy or by doing lots of research rather than adopting a simple approach, then they should do that.

The bad of course is that a complex trading approach can be time consuming and there is no clear additional benefit. Plenty of traders have been successful focusing on a single metric or reason to trade.

Moreover, an area in which leading psychologists Daniel Kahneman and Gerd Gigerenzer agree is that in the complex, real-world environment, better decisions are made using simple rules or algorithms and very limited (but highly relevant) information.

For those selling books or courses on trading or investment however, there's probably a better chance of making sales if the strategy is fairly complex, but not offputtingly so.

There is a limit to how complex a plausible solution can be: people know to take aspirin for a headache rather than see a neurosurgeon!

But this leaves retail investors exposed to more complicated strategies than they probably need. If said books are popular, the fact more people are trying to trade these strategies makes them less likely to work too, costing the investors not only money but more time.

However, my main problem with complex approaches is caused by the second psychological principle at play here. 

I have come across it both in Influence and on behavioural economist Dan Ariely's wonderful Ask Ariely column in the Wall Street Journal this week.

The principle is: personal effort effects how we subsequently see our decisions.

In Influence, Cialdini discusses the insane hazing rituals of fraternities and sororities at US universities in comparison with coming-of-age rituals undertaken by tribesfolk and basic training in the military.

Something all have in common is making their subjects work brutally hard, because the harder they have to work to join, the more committed they will be after the fact.

The example in Ask Ariely was a reader reporting that the frustration of collecting furniture from Ikea, trying to fit the oversize boxes in his car then painstakingly assembling it made him and his wife appreciate the final product more than they thought they would when they decided to buy it. 

The harder we work for something, the more likely we are to value it. Can you see the problem?

Our brains seem to try and protect our egos by preventing us from doubting our past decisions. Especially when those decisions cost us a lot of time, effort, willpower and money.

Traders giving in to the desire to adopt a complex or time-consuming approach are putting themselves at a disadvantage compared to those who opt for simplicity. 

They are making it less likely that they will be able to cut bad positions and move on.

Worse still, most people have been warned about throwing "good money after bad" at some point in their life because we tend to invest more (and not only money) in the things we've already invested the most in, even when it is the wrong thing to do. 

Of course, there are many cases where this is not the wrong thing to do. From an evolutionary perspective, it would have been bad for survival if people could just have easily walked away from their family after an argument with their spouse or some other mishap.

Like we are finding out about most of the heuristics and biases research, whether they are helpful or unhelpful really depends on the situation and environment in which they are applied.

I think there is a generally applicable framework here. In situations where commitment can be costly and your primary concern is not enjoyment, then a quick-and-dirty approach is probably best.

At least this would be the case at first. Certainly another common trading principle is adding to your winners, so you can invest more (money, time, effort) once something is clearly working for you.

If enjoyment is the main outcome state you are hoping for, then the logical conclusion to this would be to find additional steps that make a task more difficult. This has also been used in marketing.

I may have stumbled upon this by accident, albeit in a very small way. For years I used a Moka Express to brew coffee, refusing to buy an espresso machine because I enjoyed the ritual of making it.

Now I know that I probably enjoyed the end product a bit more too.

My wife and I have taken this further recently by grinding our own coffee beans with a handheld grinder too. The taste is objectively superior, but our satisfaction when we've finished making the coffee is also now greater.

I would be interested to know about the scale of this effect to bigger decisions. For example, are people who buy homes that need fixing-up happier with where they live? 

What other big decisions are available where we might deliberately make them more difficult to increase satisfaction with the outcome?

What non-trading decisions are there where fast and frugal approaches might protect us from our bias towards complex solutions and overcommitment? I'm going to spend some time thinking about this and may follow this up in a later post.