Undercover Economist

The odds are you won’t know when to quit

‘The truth is that there are no foolproof methods for knowing when to hold ’em and when to fold ’em’

There is a strong case to be made for persistence. As a child I was told the legend of Robert the Bruce. Cowering and hiding in some dank cave in Scotland, he felt like giving up his struggle against the English. Then he noticed a spider repeatedly failing to spin a web before eventually succeeding. Heartened, King Robert returned to give the English a sound thrashing in 1314. Even for an English boy, it was an inspiring tale. If at first you don’t succeed, try again.

But there is an equally strong case to be made against being stubborn. When Irving Fisher and John Maynard Keynes failed to predict the Wall Street Crash of 1929, the two great economists reacted differently. Fisher stuck to his guns; Keynes shrugged and changed direction. Fisher was ruined; Keynes died a millionaire. If at first you don’t succeed, do something different next time.

Do we tend to quit too soon or quit too late? Are we too stubborn or not determined enough? There has been much excitement recently around the idea of “grit” — a personality trait representing commitment to and enthusiasm for long-term goals, championed by psychologist Angela Duckworth. She argues, plausibly, that grit is more important than talent in predicting a successful life.

The idea is appealing in principle but one must ask what Duckworth’s brief “grit” questionnaire is really measuring. (Perhaps I am just sore because I took the questionnaire and discovered I have less grit than the average marshmallow.)

While Duckworth’s work suggests that perseverance is vital, other psychological research suggests that we sometimes persevere when we should not. Nobel laureate Daniel Kahneman, with the late Amos Tversky, discovered a tendency called “loss aversion”. Loss aversion is a disproportionate dislike of losses relative to gains, and it can lead us to cling on pig-headedly to bad decisions because we hate to stop playing when we’re behind.

My favourite study of loss aversion concerns players of the TV game show Deal or No Deal, in which players must periodically decide whether to keep gambling or accept an offer from the mysterious “Banker” to buy them out of the game. In one notorious Dutch episode, a contestant named Frank was offered €75,000 to stop; he kept playing and lost his next gamble. The Banker’s next offer was just €2,400, which was actually a fair offer. But at that point loss aversion kicked in. With the lost €75,000 in mind, Frank refused all further deals, kept gambling and kept losing. He eventually won just €10.

A study of Deal or No Deal by behavioural economists including Thierry Post and Richard Thaler found that while Frank’s fate was spectacular, his behaviour was statistically typical. People hate to quit if they feel they’re losing.

Loss aversion warps investment strategies in a similar way. We happily sold our stocks in Google and Apple but clung on to those in Enron and Lehman Brothers. The same tendency affects house prices: we hate to sell for less than we paid. Recent research by Alasdair Brown and Fuyu Yang finds that the same thing is true when people are offered the opportunity to cash in a bet on a sporting event that is still in progress. They are happy to cash out if their team is a goal up, even though that will cut their possible gains, but they will cling on if their team is a goal down even though they could cut their losses.

I was struck by a recent FT article by equity analyst Daniel Davies describing how a portfolio based on expert research recommendations would tend to do badly, but if the same portfolio had a “stop-loss” rule that simply jettisoned stocks after a 10 per cent loss, it would tend to do very well. The stop-loss rule cancelled out the instinctive tendency to hold on stubbornly to losers. Yet Warren Buffett seems to do very well by buying and holding.

The truth is that there are no foolproof methods for knowing when to hold ’em and when to fold ’em. But I have three suggestions. The first is to look resolutely away from sunk costs and towards future prospects. Whether you paid $70 or $130 for your Apple shares should be irrelevant to your decision to sell them today for $100. Bygone profits and losses are a distraction.

The second is to persevere flexibly rather than stubbornly. Angela Duckworth’s family follows a “hard thing” rule: the children have to choose an activity, such as music or athletics, that requires dedication and practice. They’re allowed to quit but only at a natural break point and only if they find an alternative “hard thing”. That seems to steer a course between the Scylla of obstinacy and the Charybdis of laziness.

The third is to view decisions as experiments. Signing up to learn the violin is an experiment; so is moving cities or careers. Of course, one can end an experiment too early or doggedly persist too long. But viewing a decision as an experiment gives a useful perspective because experiments are always designed to teach us something. We can keep asking: what have I learnt? And am I still learning? If a new project or activity keeps teaching us new things, it is probably worth continuing — even if the lessons are sometimes painful.

Written for an first published at ft.com.

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