Cognitive Investing

I just finished reading an excellent book, Reality is Broken: Why Games Make Us Better and How They Can Change the World by Jane McGonigal.  The book draws on positive psychology, cognitive science, and society to describe how game designers have hit upon core truths about what makes us happy and have utilized these discoveries to astonishing effect.  She analyzes many different types of games and demonstrates how using some of the key ideas of their design may help to address some of the world’s most difficult and intractable problems.

However, none of the profiled games in Reality is Broken specifically address the problems faced by the self-directed investor, so I thought it might be interesting and potentially enlightening if I probed the question: is investing a game?

An immediate reaction to such a question might be something like, “No, investing is serious and games are not.”  But stop and think a bit harder, and this notion dissolves.  Games are big business.  Consider the NFL, NCAA, NASCAR, Olympics, FIFA, poker, video games, Las Vegas casinos, lotteries, horse racing, scrabble, and sudoku.  This list is just a small sampling of a much larger universe.  Many of these game-based endeavors are multi-billion dollar enterprises.  The concept of a game should not be equated to something trivial or unimportant.  The phrase, “this isn’t a game,” needs to be rethought because games can be very serious indeed.

What makes something a game?  Jane McGonigal’s definition of a game includes four ingredients: rules, a goal, voluntary participation, and feedback.  Other features commonly associated with games such as interactivity, graphics, narrative, rewards, competition, and the idea of winning are not required but are frequently present.  They can enhance the overall experience.  So if investing is a game, it needs to have

1. Rules: This is pretty straightforward: you can buy or sell any securities just about any time you want.  So can every other game player.  The actions of all the players in aggregate determine the outcome of the game.  The investing game never ends.
2. A goal: Each investor may have a slightly different goal, but most investors want to win more than lose, see their overall level of assets increase, or do better than some external target (like their peers or a benchmark of some kind).
3. Voluntary participation: No one forces anyone to invest, although the consequence of not investing may be worse than playing the game and doing it poorly.
4. Feedback: Investors do receive feedback on their progress, but how and when they receive such feedback in the investing game is a key differentiator between the investing game and other better-designed games.

This last point needs more elaboration.  A well-designed game provides prompt and accurate feedback to keep the players engaged and serves as a motivator for steadily improving performance.  Computer games are especially good at this.  In some games, the difficulty level gradually increases as the player gets better so that she is always being challenged at the edge of her abilities.  In the investing game, however, the feedback mechanism is very slow.  It may take years to make an accurate assessment of whether one’s tactics and strategy are effective.  One can certainly make judgments about how a single investment or groups of investments perform over short time frames, but a significant portion of any investor’s performance is due to factors other than the specific choices made.  Almost everyone looks smart in a bull market, but bull markets do not happen all the time.  Thus it is necessary to judge many decisions over at least one complete market cycle to distinguish between luck and skill in choosing investments.

An additional issue with the feedback mechanism is that it can be challenging to accurately calculate performance.  The definitive set of guidelines within the financial industry for measuring portfolio performance runs hundreds of pages.  Properly accounting for all cash flows in and out of a portfolio, dividend and interest payments, fees and expenses, and then adjusting everything for inflation is a daunting task if one aims for precision.  In most cases, absolute precision is not necessary, but one should be able to accurately assess whether one’s efforts are bearing fruit.

Our psychology also interferes with getting accurate feedback.  We like to think we are winners and abhor the thought that we are losers.  Thus we pay much more attention to our winning investments and attribute them to our own brilliance.  We gloss over our losing investments and attribute the underlying cause of such decisions to events out of our control.  This asymmetric judgment distorts reality, which impedes the feedback process, since if we are under the mistaken illusion that we are doing much better than we are, then there is no need to make any adjustments to our process.

When assessing our results, we need to be very careful about what we are comparing to our own performance.  If we are comparing our performance to the world’s best investor or the top performing stock or mutual fund, it will undoubtedly fall short.  But those are not valid benchmarks for comparison, even though they get a disproportionate amount of attention from the financial media.  Nor should we compare our performance to the worst performers.  And even comparing it to an average brings up the question of which average?  There are thousands of such averages to choose from.  The most frequently cited averages such as the Dow Jones Industrials or the S&P 500 is not representative of a well-diversified portfolio and should not be the sole benchmark for comparison.

So, my first conclusion is that investing can be thought of as a massively-multiplayer game, but it is a poorly designed game if the goal is to engage the players and provide a platform for continual improvement.  The slow and confusing feedback mechanism creates myriad opportunities for more knowledgeable, opportunistic players to take advantage of the naïve.

Another aspect of the investing game which distinguishes it from many others is that the consequences of success and failure are much more important than most games.  This aspect also interferes with our ability to develop our game-based skills since it focuses our minds on the consequences of winning and losing, rather than the process of playing the game to best of one’s ability.  In his book, The Upside of Irrationality, Dan Ariely relates how he conducted a series of experiments that showed how game performance degrades as monetary rewards increase.  He demonstrated this effect with games requiring both physical dexterity as well as mental acuity.  Think of the choke factor or stage fright as an example of how one’s performance can degrade as stakes increase.

A second conclusion is that one should never forget who else is playing the game. Many of these players have vast experience, knowledge, and resources and will happily welcome you into “their” game so that they can take advantage of your predictable mistakes so they can profit from your judgment errors.  They are the ones who are buying at the bottom of a market plunge, when the naïve are selling in a panic.  Many of them will try to convince less sophisticated investors that they have the simple secret to success, which requires that you do what they tell you to do (for a fee, of course).  If they are successful enough at convincing others that they can play the game better than others, they don’t need to play the game anymore.  They are playing a different game, which is dependent on keeping their customers uneducated and dependent on their alleged wisdom.  If you think this describes a large chunk of the finance industry, you are on target.

By equating the investing world to a game, it highlights the important role of feedback and its shortcomings.  By focusing on improving the process of playing the game instead of the consequences of winning or losing, one can achieve long-term success.  Success in this game is not dependent on how much time or effort is expended, even though that may be easier to measure accurately.  Many participants spend huge amounts of time and effort and never progress because their focus is misdirected.  They don’t understand the critical difference between investing and gambling, and their gambles lead to random results.  Instead, one needs to understand the key elements of a comprehensive investment decision-making process.  This web site and its related book, Cognitive Investing, are educational tools that self-directed investors can use to gain such an understanding.  It will lead to key insights and increase the chances of winning the investing game.  And finally, if you want to understand more about the sociological and psychological impact that games are having in today’s world, read Reality is Broken.