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Sunday 14 June 2009

B.F. Skinner's Stockmarket Slot Machines

Win Big, Win Rarely, Win Never

Psychologists have long trailed in the wake of retailers and gaming companies when it comes to understanding the triggers that make people spend money. Slot machines, for instance, rely on the effect of variable interval operant conditioning to increase their takings.

Or, to put it in English, they pay out only rarely but when they do they pay out big. Turns out this makes people gamble more. Those investors who like to run small portfolios and look for big returns should take note.

Of Dogs and Pigeons

Operant conditioning is one of the oldest areas of modern psychology and arose out of the observation that people and animals can be conditioned to respond to stimuli in different ways. So if every time your dog chases a cat you give it an electric shock it’ll pretty soon figure out that chasing cats is not the pleasurable activity that instinct suggests. Although it may develop some strange theories about the remote electrical properties of cats.

Psychologists used to love this stuff. Behaviourism, championed by B.F. Skinner – simultaneously a great man and one of the twentieth century’s worst examples of man with a hammer syndrome, insisted that operant conditioning explained all behaviour and refused to accept the possibility of the existence of an inner mental life. If he couldn’t measure it, it didn’t exist. So much for those flashes of inspiration we dream we have from time to time.

Behaviourists, followers of Skinner, liked nothing more than having students spend hours making pigeons peck targets in order to get fed. Quite how this translated into any useful insight into the human psyche was never entirely clear, but it sure kept pigeon breeders busy and psychology students clear of bars. Meanwhile gaming companies were more practically figuring out how to make money out of the concept.

Postive and Negative Reinforcement

Operant conditioning says that if every time you behave in certain way you receive a certain response you’ll receive reinforcement which will modify the original behaviour. Reinforcement can be positive – pigeons getting fed and students hitting the bar – or negative – dogs getting shocked and cats incorrectly learning that dogs always run away from them. Thus reinforcement can either increase or decrease the target behaviour.

As it turns out the effect of continual positive reinforcement wears off after a while but if you vary the application of the reinforcement it strengthens it. So if the pigeon doesn’t always get fed then it will peck its target more, just as long it occasionally works. Although one might wonder if it was just hungry and annoyed. However, it’s been shown many times that intermittent reinforcement strengthens reinforcement.

Variable Slot Machine Payouts

Slot machines work on the same principle. The machines are programmed to ensure that the operator always wins a fixed proportion of the take so the aim of the supplier is make sure people push as many coins into it as possible, because that maximises revenue. Paying out the winnings as a continual stream of small payments, in turns out, is less good at keeping people sticking money in than the occasional big payment accompanied by flashing lights and noisy sirens. This is variable operant conditioning in operation.

That people will risk more money in order to earn the same amount in a big payment than in a small one isn’t rational, but it is an observed fact. It also means that a player may run out of money before they ever strike it lucky. The problem for many investors is that they play the stockmarket like a slot machine, running small portfolios of risky stocks in order to win big. The positive reinforcement of the occasional big win far outweighs the negative effects of the losses sustained to achieve it.

Oddly, one corollary of this is that as risk often equates to reward such investment slot market strategies can result in excess returns. That is, slot machine investors may make more money than more rational investors because they’re inadvertently taking on higher risk in their quest for the adrenaline rush of a big win.

Small Portfolios Are (Mostly) Always Dumb

Underlying this finding is Harry Markowitz’s work on Portfolio Theory which showed that volatility is correlated with portfolio size and constituents. Where risk is equated with volatility then a balanced portfolio is lower risk. On the other hand the kind of small, unbalanced portfolio run by the slot machine investors is definitely higher volatility and that can just as easily lead to outperformance as underperformance.

Compounding the growing irony of this is that there are two groups of investors who run small, unbalanced portfolios. The first are our variably operant conditioned slot machine players, the second a group of ruthlessly efficient, analytic and highly skilled investors who really know what they’re doing. It’s an unfortunate fact that you will find many people from the former group who insist that they’re in the latter because the shape of their portfolio is the same.

As an example, I once came across someone explaining earnestly that their small portfolio of UK micro-cap stocks boasting little in the way of earnings, assets or competitive advantage was the incarnation of Warren Buffett’s approach to stockmarket investing. It was like listening to a Sunday afternoon golfer comparing themselves to Tiger Woods because they’d got the same club selection in their bag. Sad, but also strangely amusing.

So, Do The Ignorant Accumulate the Money?

Edward M. Miller in Do The Ignorant Accumulate the Money has done some research around the effect on the stockmarket of slot machine investors and reckons that there are periods where waves of stupid money can genuinely cause the rough efficiency of the market to break down. He also shows that these effects can’t last forever – if the stupid money is going into unproductive assets the lower return on these will eventually affect prices, especially as sensible money will be going into cheaper, productive ones.

In fact this isn’t too surprising to anyone with a background in social psychology – you don’t need to really understand economics to recognise that waves of irrational behaviour can sweep through groups linked by social ties. One of the oddest forms of behaviour is that a group’s overall opinion on some subject will tend to be more extreme than the average opinion of the group members. This polarisation effect is to do with the intinct towards group conformity and in the markets can lead people into taking more extreme and committed positions on individual stocks and markets than they would have taken on their own.

Throwing Incaution To The Winds

That some investors will seek the thrill of a big win over careful asset allocation shouldn’t be a surprise and nor should the fact that dumb money can sometimes succeed where smart money fails. This all gets exacerbated by the professional investment industry’s need to hop on the nearest trend in order to keep up their short-term investment performance, so any dumb money effect can easily end up being amplified. For those us for whom this isn’t a game, however, capitalising on these effects is difficult and dangerous.

The effects of social polarisation and of variable operant conditioning can be incredibly hard to overcome once you become susceptible to them and for the most part we’re better off staying clear of these trends, looking for stuff that the dumb money’s left behind and waiting for the tide to come back in, carrying the sad remnants of tattered dreams and lost fortunes. Some dumb money will get lucky, that’s inevitable, but a lot of the gains will be thrown away in the continuing quest for the pleasurable stimuli of the next big payout.

Best not to play the stockmarket like a slot machine. Actually best not to play anything like a slot machine, especially a slot machine, because the odds will never work in your favour. B.F. Skinner could have told you that.

Related Posts: Newton's Financial Crisis - The Limits of Quantification, Markowitz's Portfolio Theory and The Efficient Frontier


  1. An excellent illustration of why investors prefer active funds offering the potential of a big gains over tracker funds that only deliver modest, but reliable returbs.

  2. The stock market is something in which investors try to speculate for a better progress of their investments.