This post was originally made on June 20, 2006 on a former blog of mine.

We, as humans, have an uncanny knack for continuing along a path of destruction as long as we have some sort of intermittent positive reinforcement. This pattern can be attributed to our tendency to display near term informational biases. What that means is that you give more weight to something that has happened very recently than you do to events that happened a greater time ago. If the stock market went up yesterday then most people will say it will go up tomorrow, even if it went down the prior 4 days before that.

To better understand this phenomenon let’s look at a few real life analogies. Anyone who has every played the sport of golf realizes what a wonderfully joyous game it can be on one hand and what a frustrating, depressing game it can be on the other. You make one good shot and that feeling of euphoria will stay with you for several holes, even if the ensuing shots are horrible. Likewise, if you have made three triple-bogeys in a row, then sticking a 150 yard shot 6 inches from the cup for a kick in birdie on the next hole will give you enough positive reinforcement to last a while longer. We always fall folly to the thought that if we just did it then we have a higher likelihood of being able to do it again. So even though a 25 handicapper may never really be improving his game, he can still enjoy it week in and week out because golf throws him the intermittent positive reinforcement to keep him coming back for more. It is this hope that provides the game with power over us humans.

If you’ve ever played slot machines or sat around and watched someone who has then you know that the slots make money for the very same reason. You can lose $50 on quarter slots, but if you somehow then get that $35 intermittent payoff (which all slots are programmed to do) then you believe in your heart that you are a winner and that luck is on your side and that the next pull could be the “big one”. Casinos make money from intermittent positive reinforcement just like golf courses and unfortunately, just like the people taking the opposite side of the trades you make when you fall prey to it while investing.

Because we tend to place more importance on recent events, we tend to evaluate our investment positions too frequently and make poor long term decisions. I just wanted to stress this positive reinforcement thing because you need to be aware of it if you are investing/trading. An awareness of the possible psychological biases you hold is the first step to conquering them. From an investing standpoint, knowing this might help you avoid throwing money at a dead cat bounce when the market internals are pointing to a more bearish risk scenario. It may also help you enter the market a bit earlier when there has been a significant sell-off even though some market fundamentals haven’t changed a lick.

What happened yesterday indeed has an effect on what will happen today. However, it may not have the magnitude we would ascribe to it, nor would it negate the many undercurrents that came before it. Take a longer term approach when evaluating all data. Each bit of information has its uses and is time sensitive but don’t let yourself be deluded by this bias into making poor decisions.

“Our knowledge of the way things work, in society or in nature, comes trailing clouds of vagueness. Vast ills have followed a belief in certainty.” -Kenneth Arrow: I know a Hawk from a Handsaw

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