Sunday, May 19, 2013

Knowing When to Quit


It’s a great ethical issue. How do you know when to walk away from a losing investment and when to hold on tight?

It's easy to mock people who refuse to take a loss, but contrarian investment strategy suggests that you ought to buy more when the general consensus and your instincts are telling you to sell.

How do you know when the relationship in which you have invested your time and energy and prestige is not going to work out?

Is there a magic formula that will tell you when you relationship has nowhere to go but down? How do you know that a little more effort will turn things around?

No one framed the issue better than Kenny Rogers in his song, “The Gambler:”

You got to know when to hold 'em, know when to fold 'em,
Know when to walk away and know when to run.
You never count your money when you're sittin' at the table.
There'll be time enough for countin' when the dealin's done.

Now Ev'ry gambler knows that the secret to survivin'
Is knowin' what to throw away and knowing what to keep.
'Cause ev'ry hand's a winner and ev'ry hand's a loser,
And the best that you can hope for is to die in your sleep.

If you are playing poker, Rogers says, you can know what to do by reading opponent’s face. If you are good at the game you can read his eyes and know whether he is bluffing or not.

Of course, if you opponent is also a great poker player the “tells” will be less obvious and might even be deceptive.

Heidi Grant Halvorson addresses these questions in The Atlantic. She focuses on people who tend to hold on to a losing hand too long.

It’s a complex issue. Sometimes, it’s right to take a loss. Sometimes it’s right to persevere. Perseverance can be a sign of good character. Bull-headed optimism that ignores reality is not.

Sometimes the extra investment will bring you an outsized reward. Sometimes you will be throwing good money after bad.

Psychologists tend to assume that there is a right decision and that if our minds were properly rational we would naturally be inclined to make it. Often, there is no clear right or wrong thing to do, so we balance levels of risk against possible rewards.

Halvorson offers the example of a company that is building a new type of airplane. They have advanced their project to the point where they are almost ready to complete the prototype. They only need to invest a little more money in the final stage.

But then, they discover that a competitor has completed its own prototype of an airplane that does what theirs can do, at a lower cost and more effectively.

In that case, there is no ambiguity. Continuing the ill-conceived project is throwing good money after bad. It does not take very much discernment to know what to do.

In most situations, the answer is anything but clear. Let’s say that you have invested several years in a relationship. It is a good relationship. You are hoping that it will become a marriage. Your friends and family like the two of you as a couple. You might even be living together. Now, your paramour is not sure about marriage; he or she is asking for more time.

Should you stay or go? Should you invest more in a good relationship or end it and go looking for someone who is less hesitant about marrying you?

One might also ask whether the crisis can be managed more effectively if we understand that there are options besides staying and going.

Economists and psychologists who have studied these issues have focused on the self-defeating behaviors that occur when people refuse to take a loss.

If you need to see the bet or to fold you know that if you fold your hand you will have lost. If you see the bet, you might win and you might lose.

Which is better the certainty of defeat or the possibility of victory?

Of course, if you know that you will definitely lose, wagering more on the hand is foolish. If you don’t know to a certainty, it becomes less foolish.

When economists and psychologists say that we refuse to quit because we hate to take a loss, they ignore the fact that there is more virtue in perseverance than in quitting. The former has a better reputation than the latter.

Halvorson explains some of the reasons we might use to rationalize not quitting when we should quit:

We may throw good money after bad or waste time in a dead-end relationship because we haven't come up with an alternative; or because we don't want to admit to our friends and family, or to ourselves, that we were wrong. But the most likely culprit is this innate, overwhelming aversion to sunk costs.

Sunk costs are the investments that you've put into something that you can't get back out. They are the years you spent training for a profession you hate, or waiting for your commitment-phobic boyfriend to propose. They are the thousands of dollars you spent on redecorating your living room, only to find that you hate living in it. Once you've realized that you probably won't succeed, or that you are unhappy with the results, it shouldn't matter how much time and effort you've already put into something. If your job or your boyfriend have taken up some of the best years of your life, it doesn't make sense to let them use up the years you've got left. An ugly living room is an ugly living room, no matter how much money you spent making it so.

This is easy if the decision is that clear. But, how do you know that you are in a dead-end relationship? How do you know that nothing can save it?

Psychologists from Northwestern University have offered a useful suggestion here. Instead of fretting about the loss involved in quitting, try looking at the potential profit.

If you are tempted to throw some more money into the pot because you cannot accept to have lost your “investment” think of what else you might do with that extra money. Think in terms of potential gain, not certain loss.

Halvorson explains:

Recent research by Northwestern University psychologists Daniel Molden and Chin Ming Hui demonstrates an effective way to be sure you are making the best decisions when things go awry: focus on what you have to gain by moving on, rather than what you have to lose. When people think about goals in terms of potential gain, that's a "promotion focus," which makes them more comfortable making mistakes and accepting losses. When people adopt a "prevention focus," they think about goals in terms of what they could lose if they don't succeed, so they become more sensitive to sunk costs. This is the focus people usually adopt, if unconsciously, when deciding whether or not to walk away. It usually tells us not to walk away, even when we should.

So, it’s easier to take a smaller loss when you compare it to what you might gain by using using the investment otherwise. It might also be easier to take a small loss when you believe that you are facing a larger loss.

Then again, people who double down on losing hands are also thinking of potential gain. They believe that they can win the pot.


3 comments:

  1. I started to use the words from the Gambler a few years ago in almost everything I did and now do. The idea is to build, not to tear down. One has to know when their mind and body are telling them that it is time to step back and take a break.
    As an analyst, one of the best things that aided me in solving a problem was to walk away and do something or nothing else. Invariably when I came back the ideas just seemed to flow. I use the same approach in playing music. Recognize when you hit the "wall."
    I think what happens is that one's conscious mind can only work so much, and is slower, before it rebels, so to speak, and tells you so if one listens. Whereas one's unconscious mind is constantly working in a very fast manner and will provide a number of ideas and paths if one can keep the conscious mind from interfering with it. One's unconscious mind will provide the visualizations that the conscious will utilize.
    If one learns to compartmentalize it is easier to learn to trust one's unconscious mind. This is especially true for very complex problems, composing music or playing Jazz.
    One can only hope that when one matures that they recognize it is time to teach, manage, allow other's to grow and succeed and finally just enjoy the accomplishments of others.

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  2. "Instead of fretting about the loss involved in quitting, try looking at the potential profit."

    Devil's Advocate: Doesn't doing this in the field of political thought lead to radical utopianism?

    If we don't fret about the loss involved in "quitting" current social/political/economic arrangements, and instead look at the "potential profit" of a whole new way of doing things, aren't we following in the lead of Marxists and other revolutionaries?

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  3. I meant that we should be looking at both and balancing one against the other.

    ReplyDelete