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Investors Fail The Marshmallow Test
12-24-2018, 09:02 AM,
Investors Fail The Marshmallow Test
Investors Fail The Marshmallow Test

<p><a href=""><em>Via,</em></a></p>

<p><strong>“Investors don’t like uncertainty” may be an old Wall Street adage, but it always comes to us across as a bit superficial.</strong> After all, everything in life is uncertain. If uncertainty were really a stumbling block to putting capital to work, no one would invest a dime.</p>

<p><strong>The right statement in our book is that “Investors prize predictability”, and behavioral finance both supports this construct and even helps explain its origins</strong>. To understand how, we need to briefly discuss something called the Marshmallow Test. Let’s start with the original work on the topic:</p>

<ul type="disc"><li>Researchers at Stanford University in the late 1960s developed the test for toddlers enrolled in its own kindergarten program. The idea was to assess which children had an innate ability to defer gratification.</li>
</ul><ul type="disc"><li>The original study tested to see if an unsupervised toddler (3-5 years old) could avoid eating a treat (hence the name of the test) for 10-15 minutes when promised a second treat if they could wait without an adult in the room.</li>
</ul><ul type="disc"><li>The researchers noted which children could/couldn’t wait the 10-15 minutes, and then followed their subsequent academic and social progress through grade school, college, and into the real world.</li>
</ul><ul type="disc"><li>The children who could wait the 10-15 minutes ended up getting better grades throughout their scholastic life, higher paying jobs in adulthood, and were less likely to divorce if ever married.</li>
</ul><p><strong>For decades, common wisdom held that some children had the “it factor” to wait while others didn’t, but more recent research shows the toddler’s environment matters a lot as well. </strong>A graduate psychology student working in a homeless shelter during the Great Recession realized that no child she encountered there would ever “pass” the Marshmallow test. Their family’s lives were too uncertain to ever trust that a researcher would actually deliver on their promise of a second treat. She went on to structure a new version of the Marshmallow Test where the young child subjects had cause to question the researcher’s reliability/promise of a second treat, and sure enough more of them “failed” the test.</p>

<p><strong>The Marshmallow Test, therefore, doesn’t measure the child as much as it measures the household in which he or she lives.</strong> If adult caregivers deliver on their promises and provide a stable home environment, the child learns trust. Deferred gratification is a function of this structure as much as simple personal discipline.</p>

<p><strong>Investing, of course, is nothing but an exercise in trust and deferred gratification. </strong>Personal investors see this most keenly, since they choose to invest rather than consume. But even the savviest institutional portfolio manager isn’t immune to this dynamic. How much risk they take is a function of current market volatility. And that stems from how much trust markets place in the notion that current prices are “right”. High trust equates to low volatility and rising prices. Low trust makes for, well, the current tape.</p>

<p><strong>US Google searches for the term “Dow Jones” is one broad-brush example of how volatility impacts trust.</strong> We regularly use this query as a proxy for how much retail investors are worried about the state of domestic equity prices. It’s search volume exceeds both “stock market”, “S&P”, and S&P 500”, for example. Three observations about this data point:</p>

<ul type="disc"><li>February’s volatility storm may have eventually led to new highs for US equities in September, but retail investors didn’t forget the shock.</li>
</ul><ul type="disc"><li>Search volumes for “Dow Jones” were consistently higher from March to October 2018 than the same period in 2017 by 100-150%. Since the start of recent declines, searches volumes are +200% higher than last year.</li>
</ul><ul type="disc"><li>Translation: US equity volatility from February to May 2018 did real damage to retail investor confidence that the investment climate was predictable and therefore trustworthy. They started checking price levels much more often than 2017. Now, of course, their fears have been confirmed.</li>
</ul><ul type="disc"><li>You can see the data here:</li>
</ul><p><a data-image-external-href="" data-image-href="/sites/default/files/inline-images/2018-12-24_4-44-04.jpg?itok=BkaIJO42" data-link-option="0" href=""><img data-entity-type="file" data-entity-uuid="d44bd98a-c6ae-4cc1-8c3e-59928f972b2b" data-responsive-image-style="inline_images" height="128" width="500" srcset=" 1x" src="" alt="" typeof="foaf:Image" /></a></p>

<p><strong>Just as important as all this: American workers know declining stock prices can portend recessions and accompanying corporate layoffs. </strong>US Google searches for “recession” have spiked in recent weeks to levels 3x those of the last 5 years. The geographic area most likely to search for the term is Washington DC, which shows policymakers are acutely aware of how stock market volatility informs their constituents’ faith in the economy. Worryingly, California residents come in at #4 on Google’s state-by-state list of citizens Googling “recession”.</p>

<p>See the Google search data for “recession” here:</p>

<p><a data-image-external-href="" data-image-href="/sites/default/files/inline-images/2018-12-24_4-45-17.jpg?itok=pO3Xtoh0" data-link-option="0" href=""><img data-entity-type="file" data-entity-uuid="877acc79-d3a3-4697-b55b-2b8317a9d244" data-responsive-image-style="inline_images" height="130" width="500" srcset=" 1x" src="" alt="" typeof="foaf:Image" /></a></p>

<p><strong>The bottom line here: the Marshmallow Test shows that unpredictability/volatility is the essential linkage between Wall Street and Main Street, not whether stocks are down 10% (a “correction”) or 20% (a “bear market”). </strong>Current unknowns, from Fed policy to trade wars and now White House turmoil, are proving too heavy a weight to allow US equity markets to find their footing.</p>

<p><a data-image-external-href="" data-image-href="/sites/default/files/inline-images/20141011_BKP002_0.jpg?itok=WBoz-HXX" data-link-option="0" href=""><img data-entity-type="file" data-entity-uuid="5694289e-dc2c-4a65-aa5b-ac970a408de5" data-responsive-image-style="inline_images" height="282" width="500" srcset=" 1x" src="" alt="" typeof="foaf:Image" /></a></p>

<p><u><em><strong>This needs to change, both in form (fewer worrying headlines) and substance (lower stock price volatility), soon or the US consumer could easily talk themselves into a real recession instead of just Googling the term.</strong></em></u></p><img src="" height="1" width="1" alt=""/>

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