6 reasons why we panic during a market correction

Recently I had the opportunity to make a presentation for Tamil Nadu Investor Association.

I had covered the various psychological biases which impact us during a market correction and some possible solutions to work around this problem.

I am sharing the presentation here and hope you find it useful ūüôā

 

If you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox. Cheers!

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Musings under the shower series: Lottery linked equity mutual funds

In search of the holy grail for long term investing..

While people like me keep harping about the merits of investing in equity mutual funds for the long run, let us be honest – this stuff though it’s simple is really tough to execute.

Now what if you and I were given the chance to solve this problem for the mutual fund industry.

How would we do this?

My two cents below..

The fascination for lotteries

Recently my mom returned from a trip to Kerala and had a surprise for me. She had bought along with her a few lottery tickets and asked me to check for the results.

Monsoon-Bumper-Kerala-lottery.jpg

Now while I knew that the odds of us winning a lottery was obviously minuscule, still for a minute I was subconsciously dreaming about the possibilities of what all we could do if we won the lottery.

However irrational, the prospects of winning was damn exciting!

The fact that I am still writing this blog post on a lazy Sunday afternoon gives you a clear sense of my lottery results.

Leaving my sad story behind, have you ever wondered..

Why do lotteries lure us?

Behavioral scientist Dan Kahneman explains it beautifully

‚ÄúWhen the top prize is very large, ticket buyers appear indifferent to the fact that their chance of winning is minuscule. A lottery ticket is the ultimate example of the possibility effect. Without a ticket you cannot win, with a ticket you have a chance, and whether the chance is tiny or merely small matters little. Of course, what people acquire with a ticket is more than a chance to win; it is the right to dream pleasantly of winning.‚ÄĚ

Thus, for most of us, while the odds are low it is the hope of “what if it could be me” and the opportunity it provides for us to dream about winning, that motivates us to spend on lotteries.

So here is the crazy idea –

What if we could add a free lottery ticket element to equity mutual funds!

The plan goes like this,

Currently the top 3 mutual fund companies – HDFC Mutual Fund, ICICI Mutual Fund & Reliance Mutual Fund make profits above Rs 500 cr.

They decide to keep say Rs 30 cr out of their profits every year to reward investors who have trusted them and have stayed with their funds over the long run.

Lottery 1: Rs 1 cr each for the lucky 10 investors picked randomly

People eligible for this:

  • Anyone who has done a continuous SIP streak of more than Rs 10,000 per month for a period between 5 to 10 years (if there is a break in between the investor wouldn’t be eligible) in any of their equity funds
  • Anyone with an initial investment above Rs 5 lakhs initial investment and has stayed for a period between 5 to 10 years in any of their equity funds

The overall idea is to give the investors an incentive to stay put with the funds over a reasonably long period of time and experience the power of long term in equities.

Lottery 2: Rs 2cr each for the lucky 10 investors picked randomly

  • Anyone who has done a continuous SIP streak of more than Rs 10,000 for a period more than 10 years (if there is a break in between the customer wouldn’t be eligible) in any of their equity funds
  • Anyone with an initial investment above Rs 5 lakhs initial investment and has stayed for more than 10 years in any of their equity funds

Once a person wins the Lottery 1 he wont be eligible for participating in Lottery 1 for the next 10 years. He can prolong his holding period to 10 years and participate in Lottery 2.

Again once a person wins the Lottery 2 he won’t be eligible for participating in Lottery 2 for the next 10 years.(The idea being that, he has a real life experience of the merits of long term investing and will be a much better investor going forward. Also this creates the space for others to benefit)

The ultra rich can be disqualified by having a cut off based on annual income tax paid or some other method.

This lottery process will happen every year. So even if the investor is not selected this year, there is always the incentive to extend the holding period for another year and participate again.

As the mutual funds become more profitable, the prize money and the number of people chosen can be increased.

Now even if you don’t end up lucky, assuming you held on till 10 years, then more often than not you will be mighty pleased with your original investment outcome.

What do you think about this idea? Will this work?

There is nothing more powerful than all of us putting our brains to solve this problem. So it would be fun if you could pen down your suggestions/ideas in the comments section.

Who knows, we might end up discovering the holy grail of long term investing..

P.S: As with most ideas, we as humans will try to game the system. If there is something that I have overlooked do let me know. We can improve upon this.

And also I have conveniently ignored the regulatory angle (the strict SEBI). The idea is to come up with some creative ideas and hopefully we can make it work someday.

As always happy investing folks.

If you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox. Cheers!

If in case you need any help regarding your investments or want me to write about something, feel free to get in touch at rarun86@gmail.com

Oops the markets are falling – Spying on investor behavior – Part 2

Exploring the strange habit of selling near the bottom

In our last week’s post here, we had explored how our lizard brains which evolved millions of years ago are still stuck with their primary functions of ensuring our survival and hence end up doing a messy job when it comes to handling falling markets.

Today, we will explore the second behavioral enemy – Loss Aversion

Loss Aversion – Pain from a financial loss is twice the pleasure from a similar gain..

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Behavioral scientists Daniel Kahneman and Amos Tversky have done several experiments to understand how we humans psychologically react to losses vs gains.

Their key finding was that:

  • We all hate losses more than we love gains (duh, didn’t we all know this)

But here is where it gets interesting

The pain  from a financial loss is almost two times the pleasure derived from a similar gain!

  • The result is that investors tend to make poor decisions as a consequence of trying to avoid the pain of a relative or absolute loss
  • This phenomenon is called loss aversion

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Source: Franklin Templeton

So as the equity markets fall, the emotional pain that we experience is much more intense than the pleasure we had earlier experienced from similar gains.

Frequent monitoring of portfolios aggravates loss aversion..

Now as if this emotional pain was not enough, we further aggravate it with yet another behavior of ours – frequent monitoring of portfolios

The advent of mobile apps, has made it much more convenient to track our portfolios anytime, anywhere.

But this has a flip side, as it has been found out that:

The more we evaluate our portfolios, the higher our chance of seeing a loss and, thus, the more susceptible we are to loss aversion

In a market correction usually we are anxious of what if this extends and becomes permanent. This usually leads us to monitor our portfolios more frequently during a market correction (based on anecdotal evidence witnessed from our clients).

Suddenly we have a deadly situation – Loss aversion on steroids!

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The reason why most of us panic and sell during a market correction must be obvious to you by now..

The lethal combination of loss aversion and frequent portfolio monitoring implies significant emotional pain during a market correction. In an attempt to avoid the pain we end up selling our equities.

But wait a minute, are we missing out something..

More than what meets the eye..

Now if this was the case, then most of us must actually end up selling our equities in the initial stages of a correction. However, historically investor behavior during a bear market suggests that majority of investors hang on for the initial part of the correction and usually cave in close to the bottom of the market.

 

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Investor emotions gradually moves across..

Initial stages of fall“It is only a temporary decline. I am in for the long run”

As the fall continues and prolongs“Phew. I give up. Maybe the markets just aren’t meant for me”

What explains this?

To understand this peculiar behavior we need to explore two more behavioral quirks

  1. Our Pattern Seeking Brain
  2. Cognitive Dissonance

Our Pattern Seeking Brain – The desire to see patterns in the market and extrapolate them into the future..

Humans have a remarkable ability to detect patterns. That‚Äôs helped our species survive, enabling us to plant crops at the right time of year and evade wild animals. But when it comes to investing, this incessant search for patterns causes more heartache than anything else.” – Jason Zweig

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Our brains are hard-wired to believe we can predict the future and make sense out of random patterns. In fact, it even, it even rewards us for doing so.

Further, according to the author Dan Solin,

The brain of a person engaged in pattern seeking and prediction, experiences the same kind of pleasure that drug addicts get from cocaine or gamblers experience in a casino.

Thus our never ending search for patterns in the equity markets leads us to assume that order exists in the markets. However the harsh reality is that stock markets are far more random and unpredictable than we like to admit.

Let’s put his insight into the current context..

The Indian equity market (represented by Sensex) is down ~10%

sensex Google Search

What will happen to the markets going forward? Will the correction continue?

The honest answer is “I don’t know” (an even more honest answer is no-one knows)

But unfortunately our pattern seeking brain is already on to its prediction mode..

All recent market corrections have been followed by a sharp recovery – Taper Tantrum in 2013, China concerns & Oil crash in 2015-2016, Demonetization in fag end of 2016

SENSEX BSE Sensex Sensex Index Live Sensex Index Sensex Stocks

So our pattern seeking brain expects the same pattern to repeat this time too.

So we ride out the initial part of the decline as we expect the earlier pattern of quick recovery to repeat. Now if it repeats, well and good. Else we are in for a shock!

Eventually in equity markets, it is only a matter of time before which the pattern gets broken and the market decline prolongs. (but when it happens is anyone’s guess)

And the moment our identified pattern is broken, all hell breaks loose. We panic, our predictions go for a toss and you know the rest of the story –

We end up selling near the bottom!

Let us move on to the second explanation of why we panic close to the bottom.

Cognitive Dissonance: The action-belief mismatch..

The psychological discomfort that we feel when our actions are not aligned with our beliefs is called cognitive dissonance. All of us strive to avoid this as much as possible.
When cognitive dissonance happens, we try to reduce in different ways.

Remember the Aesop’s fable ‚Äď ‚ÄėThe Fox and the Grapes”..

Driven by hunger, a fox tried to reach some grapes hanging high on the vine but was unable to, although he leaped with all his strength.

As he went away, the fox remarked, ‚ÄúOh, you aren‚Äôt even ripe yet! I don‚Äôt need any sour grapes.‚ÄĚ

The problem is that in order to reduce the dissonant feeling we can sometimes become biased to self-deception. We can be drawn into simplifying narratives or illusions or become guilty of rejecting valid but contrary viewpoints.

In a bear market, here is how cognitive-dissonance plays out in an investor

Most investors have created a self image of being a good decision maker. They believe they are intelligent and diligent investors and can predict the markets.

Self esteem Paige Soller Flickr

In a falling market, as our investments decline in value, we don’t like to admit that we were wrong. Cognitive dissonance sets in as the new reality – that our investments have declined conflicts with our own view of us being good decision makers.

Selling and realizing a loss only reinforces this and hence we will be reluctant to realize losses even when investment performance is bad. This leads to what is called the ‚Äúdisposition effect.‚ÄĚ i.e we stick to our investment holdings despite loss.¬†

As the market fall continues, the cognitive dissonance continues to increase, but at the same time we cannot sell as it would hurt our ego and self image.

How do we find a way out of this?

As always, we come up with a cunning solution..

Looking for someone to blame

keep-calm-and-blame-someone-else-1

The solution is simple – Let us put the blame on someone..

“My advisor is a cheat..he should have seen this coming”

“My fund manager sucks”

“The broker recommended me this dud stock”

Phew. Now that we have a scapegoat, we can relax. We suddenly find this a behaviorally easier solution to resolve our cognitive dissonance as we can still can maintain our positive self-image. 

And hence we end up selling, and at the same time manage to keep our self image intact!

Bear market behavior – Complex interplay of loss aversion, frequent monitoring, pattern seeking brains and cognitive dissonance

In the initial part of the market decline, the tendency to sell due to emotional pain from loss aversion and frequent monitoring is negated by our pattern seeking brain (which expects a quick recovery as seen earlier) and cognitive dissonance (which doesn’t allow us to sell to maintain our self image)

But as the decline extends and takes the form of a bear market, the emotional pain pain from loss aversion and frequent monitoring significantly increases. Further the earlier patterns are also broken and we seek to resolve our dissonance by blaming someone else.

As all these factors come together, we usually end up selling near the bottom of the bear market.

This post is not designed to argue that we should not sell equities in a bear market – in fact if the earlier investments were bad it makes all sense to sell out as early as possible.

However if the investments are good and a long term investment strategy is in place, panicking and not sticking to the plan can have disastrous consequences for us.

Thus the idea is to highlight the distinct behavioral challenge that all of us will face in a bear market.

Quick Summary

  • Loss Aversion
    • The pain¬† from a financial loss is almost two times the pleasure derived from a similar gain!
    • The result is that investors tend to make poor decisions as a consequence of trying to avoid the pain of a relative or absolute loss
  • Frequent Monitoring
    • The more we evaluate our portfolios, the higher our chance of seeing a loss and, thus, the more susceptible we are to loss aversion
  • The lethal combination of loss aversion and frequent portfolio monitoring implies significant emotional pain during a market correction.
  • Pattern Seeking Brain
    • Our brains are wired to seek patterns
    • Our brains are still stuck in the earlier patterns of intermittent declines followed by quick recovery which is common in a bull market
    • The brain expects this correction to be no different and hence doesn’t want to sell right now
    • As the market fall extends, the pattern breaks, we panic and its the same story – we sell close to the bottom!
  • Cognitive Dissonance
    • The psychological discomfort that we feel when our actions are not aligned with our beliefs is called cognitive dissonance
    • Most investors have created a self image of being a good decision maker
    • A falling market conflicts with the self image
    • In the initial part of the fall, we hold on our equities to maintain self image
    • As the fall extends, we remove cognitive dissonance by blaming the poor decision on the advisor, broker or fund manager – and at the same time maintaining our self image
    • Thus we end up selling close to the bottom
  • In the initial part of the market decline, the tendency to sell due to emotional pain from loss aversion and frequent monitoring is negated by our pattern seeking brain (which expects a quick recovery as seen earlier) and cognitive dissonance (which doesn’t allow us to sell to maintain our self image)
  • But as the decline extends and takes the form of a bear market, the emotional pain pain from loss aversion and frequent monitoring significantly increases. Further the earlier patterns are also broken and we seek to resolve our dissonance by blaming someone else.
  • As all these factors come together, we usually end up selling near the bottom of the bear market

Now while there is an urge to come up with a solution to address this, the idea is to explore all other enemies, gain a holistic perspective as we connect the dots and at the end of it come with a solution to fight them all (hopefully).

So I plead patience for a few more weeks.

Till then, happy investing as always

For the rest of us, if you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some free, super interesting investment insights delivered straight to your inbox. Cheers!

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

 

Oops the markets are falling – Spying on investor behavior – Part 1

10 minute read

Equity market corrections are inevitable

If we are investing in equity markets, there is only one certainty Рwe will all inevitably  go through periods of market declines.

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History shows us that for Indian equity markets, it is reasonable to expect a 40%50% correction at least once every decade, 20-30% correction once every 3-5 years and 10-15% corrections almost each and every year.

But the sad part is that most of us (that includes me for sure) will find these corrections extremely stressful and there is a very high likelihood that we will panic, exactly at the wrong time.

Investor Misbehavior – Selling low and buying high

Usually this leads to disastrous investment pattern of selling low and buying high.

Image result for buy low sell high

This also ends up in what is called a “behavior-gap” i.e investor returns being far lower than the actual underlying investment returns over the long run.

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At the risk of grossly simplifying the issue, from an investor behavior point of view we have two problems to solve

  1. Selling low
  2. Buying High

Over the next few weeks, we will delve upon each of these two issues in detail and see if we can figure a way out.

First, let us focus on the 1st problem “Selling Low” and learn about the 8 enemies who influence us to sell during a bear market

Enemy No 1: Evolutionary roots and our three-in-one brain!

Scientists working on our brains have found out that while all of us have a single brain – not all parts of our brain were developed at the same time, instead, our brain actually evolved in three separate stages over millions of years as a part of human evolution.

reptillian-brainThe three brains ‚Äď the reptilian brain, the limbic brain, and the neocortex ‚Äď are radically different from each other in anatomical structure, in chemical composition and in function.

They are so different, that we can think of this as having three different brains crammed into our skull: a primal instinctive mind, an emotional mind and a rational mind.

This is called as the Triune Model of the Brain and was developed by the scientist Paul McLean in the 1960s.

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a. Reptilian Brain –

The reptilian brain, is the oldest part of the brain, the one that we share with reptiles, and has its origins about 500 million years ago.

This brain caters to the most primitive, instinctive human behaviors and the primary purpose of the reptile brain is survival, reproduction (sex) and protection.

Since this part of the brain is responsible for survival it is always active, even in deep sleep. Further, this part of the brain is NOT in our control and works at a subconscious level.

It controls the basic functions required for body maintenance like breathing, heart rate, metabolism, digestion, hunger, blood circulation etc and is also involved in arousal and responds to opportunities to have sex.

b. Limbic Brain – Head of Department, Emotions

The second to develop was the limbic brain or emotional brain.

 

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This is our emotional center which holds memories related to specific emotional events. It assigns specific emotions to events and habits.

For example, the reason why we may feel good after eating an ice cream is because the limbic system has assigned a pleasurable emotion to consuming that specific food.

The reason why we like or dislike certain activities is because our limbic system holds on to emotions assigned to that activity.

Let’s say we lost money in the stock market. Our limbic system will store an emotion of pain attached to stock markets. This event may then be the reason why we become scared of stock markets.

The functioning of the limbic system is based on the experience of pleasure or pain.

And here is the important part – we have very little control over the limbic brain.

Food, Fuck, Fight, Freeze, Flight..

Both the reptilian brain and the limbic brain together are sometimes also referred to as the Lizard Brain.

They together were designed to serve our ancestors who were were hunter-gatherers, living in small nomadic groups, pursuing wild animals for food, looking out for edible plants, searching for mates, avoiding predators and seeking shelter in bad weather.

Further the reptilian is always scanning the environment for potential threats.  Based on its evaluation of the threat along with the help of the limbic brain, it responds with a freeze-flight-fight response. (i.e it responds to threats either by mobilizing our energy for fighting back or for flight, or by freezing in helplessness in the face of an overwhelming situation.)

Sounds mumbo jumbo – check this video and you know why you need to thank your lizard brain

Seth_Godin_Lizard_Brain_GA_Course_Slide_20140409_121356_20140409_121359.png‚ÄúThe lizard is not thinking about the taxes and what he‚Äôs going to do tomorrow, how to secure his housing, mathematics; he‚Äôs just into food,fuck,fight,freeze,flight. That‚Äôs it. And it‚Äôs very real. Pure feeling.”

– Wim Woff a.k.a the Dutch ‚ÄúIceman‚ÄĚ who climbs the highest and coldest mountains in the world, shirtless only wearing shorts

Image result for wimm woff dutch iceman

Since nothing matters more than survival, we are in fact largely controlled by the lizard brain!

Also, the lizard brain overrides the rational brain when it perceives threat and our survival and safety are in question.

We are all lizards deep inside!

A lot of the behavioral biases that we have owe their reason to these two parts of the brain

c. Neocortex – The Rational Brain a.k.a The Thinking brain

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The most recent and outermost part of your brain is the neocortex, which you can think of as your thinking brain. It’s responsible for reason and logic.

It’s also the part that gets hijacked when perceived threats and high emotion take over.

So basically, out of the three brains, the Neocortex is the one which is best suited for complex decision making required for stock market investing.

Now that we are done understanding the three brains, here is a quick summary to help you remember

Our brain – Latest software upgrade on an outdated hardware

As a part of evolution as the brain evolved from primitive to advanced, it didn’t get rid of its old parts. Instead, the new parts formed on top of the old ones. The older parts stuck to their age old functions of survival. The problem now is that we have a fairly recent software which is running on a hardware upgraded millions of years ago!

This forms the foundation of an entire field called “Behavioral finance” which explores the various behavioral biases which we have due to this mismatch.

The three brains and the falling market

Usually all these three brains operate together. But there are times when a certain segment will override or heavily influence other segments. And herein lies the problem.

The rational brain (neocortex) is overpowered by the emotional (limbic) and reptilian brain during times of danger

This makes perfect sense from an survival point of view, as in the presence of fear or danger, someone who delays is at a disadvantage; a fraction of a second can make all the difference between life and death.

Step on a snake, a dog suddenly chasing you, an stone flying towards your face, and your lizard brain will jolt you into jumping, running, ducking, or taking whatever impulsive response that should get you out of trouble in the least amount of time.

But what if the lizard brain is wrong in its interpretation of danger and has received a false signal – given the instinctive response, you would have acted by then.Apparently this is still fine.

For our ancestors, this system worked perfectly well, as there was little harm in confusing a false alarm vs a real one. If your lizard brain sent you running trying to escape a tiger, you are safe. Even if it was actually only a movement in the grass due to wind which you mistook for a tiger, you still end up fine as your running away from that place did you no big harm.

Lizard brain’s premise : Better safe than sorry

But the real problem is when a potential threat is financial instead of physical.The lizard brain is only used to physical threats and never had to handle a financial threat during its hunter-gatherer times.

Hence when faced a financial threat such as a fall in markets it cannot differentiate it from a physical threat.

As a result, it triggers the same fear reaction, during a market fall as you lose money or believe that you might!

In fact according to Jason Zweig, the author of “Money and your Brain

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‚ÄúFinancial losses are processed in the same area of the brain that responds to mortal danger. Losing money can ignite the same fundamental fears you would feel if you encountered a charging tiger, got caught in a burning forest, or stood on the crumbling edge of a cliff.”

So the lizard brain in charge of our survival comes into action overriding our rational brain during a market fall when you start losing money!

This is a recipe for disaster as the rational brain which is best suited to handle investing decisions is shut off, and the old lizard brain which has no clue on the stock market is called upon to handle investment decisions.

The lizard brain still stuck in our ancestral hunter’s environment, as a response to the threat decides to take the flight response.

“Sell, Sell, Sell” shouts the lizard brain!

Unfortunately, in the world of investing, a panicky response in a falling market is usually disastrous in the long term. Selling all your stocks or equity mutual funds just because the Sensex is falling – will put you in far more trouble than it will get you out of it.

A moment of panic is all that it takes to screw up our long-term investing strategy.

The story usually ends with us fleeing the market at a low point and missing out when the market bounces back!

Thus it is important to realize that, in a falling market our lizard brain (mistaking the financial loss as a survival threat) is hell bent to make us sell out of equities.

And mind it, this is a powerful brain which has evolved over millions of years – our new age rational brain more often than not will not stand a chance against this.

Add to it the fact that, we can quickly execute our sell decisions in seconds thanks to our cellphones.

No wonder majority of us panic and sell during a market crash!

Takeaway:
To panic during a bear market is not our fault, we are all wired that way.
Blame our evolutionary roots and the lizard brain.

Thus the 1st enemy in a falling market is unfortunately our own brain and our evolutionary roots ūüė¶

(to be continued)

In the coming weeks, we shall explore each and every one of the other enemies, gain a broader perspective as we connect the dots and at the end of it come with a solution to fight them all (hopefully).

Till then, happy investing as always ūüôā

P.S: By no means am I a brain expert. So most of these learnings are from several articles, books, videos etc . The intent of this series is to primarily spur your curiosity and explore why we actually panic during a market correction. If you are brain related scientist and got pissed off at my naivety please feel free to take my case via the comment section ūüė¶

For the rest of us, if you loved what you just read, share it with your friends and don‚Äôt forget to subscribe to the blog along with the 3500+ awesome people. Look out for some free, super interesting investment insights delivered straight to your inbox. Cheers ūüôā

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

The secret techniques app designers use to get us addicted

Nowadays most of us end up spending a lot of our time on social media apps such as Facebook, Twitter, Instagram, Whatsapp etc. In the future, this trend is only expected to get worse.

Given this backdrop, I think it is extremely important that all of us get to understand some of the habit formation techniques that app developers deploy in these apps. It might give us a fair chance to still be in control of our social media usage. More so especially, if your are a parent, as the apps have their most vulnerable target in the form of your precious ones.

Let us begin with a simple question:

Why the heck are some of these apps so addictive ?

To find out the answer, we will take the help of our friend Mr. Nir Eyal, the author of ‚ÄúHooked: How to Build Habit-Forming Products‚ÄĚ and lecturer at the Stanford Graduate School of Business and Design School. Thankfully for us, he has spent a good part of his life figuring out the secret ingredients that go into habit-forming apps and products.

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So without reinventing the wheel, let us first understand what Mr. Nir Eyal has found out.

According to Nir Eyal, habit-forming and engaging apps generally deploy a combination of these 4 concepts

  1. Trigger
  2. Action
  3. Variable Reward
  4. Investment

He calls it the “HOOK” model.

Image result

What the heck!! 

Err I understand. You have no clue and these definitely don’t sound exciting by any means. But hang on and soon you will be able to connect the dots to get your “Aha” moment.

1.Triggers (“the¬†reminder to use the app”)

Just take a count of the apps in your phone. Mine is currently at 25. Phew.

But how many do you actually use regularly?

Umm.. Maybe around 5-6!

Ever wonder why?

Incomplete office work, bike to be repaired, ¬†electricity bill to be paid, vegetables to be bought blah blah…Long story short – All of us are busy. Period.

So how in the world will we remember to open and use the app.

In comes our hero Mr Trigger.

Triggers are essentially¬†“cues” which remind¬†us to take the necessary action i.e to open and use the app.

These are typically the notifications, beeps, buzzes, rings, flags, pushes, pings, SMS, email etc. that your app keeps sending in order to make you use the app.

Image result for social media notification

Almost all apps start encouraging usage by alerting users with these simple triggers.

But the addictive apps, take the concept of triggers to the next level.

Think about this. Do you open facebook only when you receive a trigger from the app?

No right. We most often also check facebook when we feel bored or lonely.

So the trigger in this case is not only the typical external one designed by the app designer. But rather it is also the much more powerful internal trigger which is basically your own emotions or feelings that you go through.

Sample this:
You are feeling bored. You check Twitter!

You are unsure of something.You check Google!

You fear missing out on your groups’ conversation. You check Whatsapp!

While all apps start with simple external triggers, the successful ones¬†gradually figure out an internal emotion or feeling which will act as a perennial and powerful trigger for using the app. So from then on, each and every time you get that emotion you will check out the app eventually creating¬†a habit.¬†Isn’t that a killer.

And here is something even more interesting –¬†between positive and negative emotions, the negative emotions are proven to be more powerful internal triggers.

People  who  are  DEPRESSED  CHECK  EMAIL  MORE  OFTEN.     Source:  Kotikalapudi  et  al  2012

So the next time you decide to check an app. Pause for a second. Was it an external trigger or an internal trigger. If it’s an internal trigger – what is the emotion or feeling which is causing you to open the app?

This transition from an external to internal trigger is the first sign of an addictive killer app.

But hang on. The trigger is fine, but will it always lead to the desired action?

For eg:
I get a notification from Myntra informing a discount sale is on. But I am least interested. So it doesn’t lead to action.

So an external trigger, unless it matches with my internal motivation¬†doesn’t lead to an action.

What about internal triggers?

I get really bored (internal trigger). But will I open the intended app?

So now we come to the next question –

When does a trigger really become effective and lead to action?

To decipher this, let’s move on to the second part of the HOOK model

2.Action (“using the app”)

Scroll

The trigger driven by internal and external cues has essentially reminded you to do the action (i.e opening and using the app). However, if you don’t take action, the trigger is useless.

So for the trigger to work i.e the action to happen, there needs to be two more additional things apart from the trigger

  1. Motivation: A person must have sufficient motivation when the trigger occurs.¬†That is basically there must be some reward (either extrinsic or intrinsic) which motivates you to do the action. Eg You open facebook to see who liked your picture – you get a social reward in the form of appreciation, recognition. We shall explore¬†this in detail under the topic of “variable rewards”.
  2. Ability:  The person must have the ability to perform the behavior when the Trigger occurs. Think of someone trying to use the photoshop app to edit images. Unless he has the ability (the know how) he wont be able to use it.

So apps primarily work around these two levers of “motivation” and “ability” to ensure that the trigger leads to intended behavior.

Generally, it is far more difficult to increase motivation vis-a-vis ability.

Hence the apps which end up creating habits, initially focus on the ability portion. They make the action as easy as possible. The easier it is do something, the more users will do it. Think about the ease of all the actions which we do in various apps Рscrolling, clicking, liking, sharing, playing a video etc

To make the action as easy as possible, app developers focus on these six elements and keep simplifying them

  1. Time: how long it takes to complete an action
  2. Money: the monetary cost of taking an action
  3. Physical effort: the amount of labour involved in taking that action
  4. Brain cycles: the level of mental effort and focus required to take an action
  5. Social deviance: how accepted that behaviour is by others
  6. Non-routine: how much the action matches or disrupts existing routine times
Level  of  of  motivation  and  ability   determines  if  action  will  occur. MOTIVATION TRIGGER  	 SUCCEEDS TRIGGER ...

Thus the app designers make the action as easy as possible, thereby ensuring that the trigger is effective.

As expected, the action phase of the hook is where the habitual behavior occurs.

So now we have

  1. A trigger which reminds us to do the action
  2. An action which is simple enough to be done

Hang on. There is still a major issue.

You have reminded me to act. Sure. You have made the action simple. Alright.

But why in the world should I do the action however simple it is. What is my incentive? 

So the app developer is now stuck with the problem of motivating us to do the action. Let us see how he solves this.

 3.Variable Rewards (rewards for using the app Рand its variable!!)

The app developers solve this issue by rewarding the actions that it triggers. Rewards are not necessarily the monetary ones . There are several others types of rewards such as social rewards, search for resources, personal achievement etc about which I have discussed in detail in the below post

A deep dive into variable rewards

But here is the killer. Researchers have found that, instead of a steady and predictable reward, if these rewards are made variable (i.e random where you have no clue on when and what type of reward you stumble upon), they produce significant cravings in us and lead to addictive behavior. Eg Slot machines, video games, scrolling twitter in search of interesting information etc

This finding is born out of research conducted on animals, for example: teaching a rat to press a lever. Researchers found that when compared to a fixed schedule (eg: a piece of cheese for every other lever presses), varying the schedule (eg: two rewards in a row after one press, then a single reward after three presses, etc) was much more effective though the overall rewards received ratio was 1 to 2.

How Variable Rewards Work - Jason Shen

I have discussed this interesting concept in detail in my earlier post here

A pigeon from the 1950s has the answer to your facebook addiction

Thus as seen above variable rewards are one of the most powerful tools that app developers use to hook users.

 4. Investment (our inputs into the app)

The last phase of the Hook is where the user is asked to do bit of work. The point of the investment phase is to ask users to put something of value into the system, which increases the likelihood of them using the product and of successive passes through the Hook cycle.

Example: Inviting friends, sharing articles, commenting, sharing pictures, updating status, sending email etc

Unlike the action phase, which delivers immediate gratification, the investment phase is about the anticipation of future rewards.

The Hook Model applied in real life..

Let us see how Facebook uses the HOOK framework to create a habit

1)Trigger

External Trigger – Notifications

Image result for facebook notification

Internal Trigger (the most powerful source of trigger)

You start using facebook whenever you are bored or lonely

2) Action

The scroll – how much more simpler can it be!!

Image result for facebook scrolling

3)Variable Rewards

The scroll action is done to get the variable rewards. There are several variable rewards that facebook deploys

  • We could get a friend request
  • Someone could tag us a in a photo
  • A friend could comment on our status update
  • A friend could have posted his/her own status update
  • Someone might have sent us a direct message
  • A friend might be online and ready to chat with us
  • We might stumble upon an awesome video shared by our friends
  • Some nice article in our news feed
  • Event invites
  • There is a discussion in our facebook groups etc

4) Investment:

Inviting friends, following people, sharing articles, commenting, sharing pictures, updating status, commenting in groups etc

Summary:

Thus an addictive app mostly has all these 4 ingredients

  1. A trigger which reminds us to do the action
  2. An action which is damn simple to do
  3. A variable reward to keep us craving for more and repeating the action (this is responsible for the addictive behavior)
  4. An input from us into the app which leads to step 1 albeit with a lag

Apply this to any of the popular apps that you are using and¬†I can guarantee your “Aha” moment.

In our next post, we will learn on how to invert the hook model and figure out on how we can slowly start reducing our app addiction.

Just in case you made it till here, do consider subscribing to the blog for further updates and free links to downloading some amazing contents on finance and behavioral psychology.

 

A deep dive into variable rewards

8 minute read

This is a continuation of my previous post on variable rewards here.

In our earlier post, we had discovered that variable rewards are a key ingredient in most of the habit forming products.

Generally we tend to equate rewards with money. But however we found from our earlier examples that there are other rewards such as information, social approval etc which can be used to create habits.

So this begets the question:

What are the “rewards” ¬†which when varied can lead to¬†habit formation?

According to the behavior design expert, Nir Eyal, variable rewards come in three types and involve the persistent pursuit of:

  1. Rewards of the tribe 
  2. Rewards of the hunt 
  3. Rewards of the self

Image result

What the F*%&??

I completely get it. But please hang on. I promise to simplify and will be well worth your time.

1.Rewards of the Tribe (read as social rewards)

Cut the crap version: People deep down want to feel connected to others

Image result

All of us are social creatures. We crave for a sense of belonging, attention, approval and appreciation from others.

“We are social beasts and still judge one another on a daily basis”
РRust Cohle ( a fictional character in the television series True Detective)

This can be explained by our evolutionary roots. Throughout our long history, communities were our lifelines. It was extremely difficult to survive the harsh weather conditions and the constant hunt for food as an isolated individual or family.So as a part of evolution, the need for being a part of community became ingrained in us.

In fact scientists have found out that humans have specially adapted neurons in their brain (called mirror neurons) that help us feel what others feel, providing evidence that we survive through our empathy for others.

Thus our brains typically crave for rewards that make us feel accepted, attractive, important and included in a community.

In a nutshell, it is about social rewards

A few examples:

Facebook, Twitter, Linkedin, Instagram and several other social media apps:
They collectively provide powerful social rewards on a variable basis to billions of people around the world. With every post, tweet, share or comment, users anticipate social validation. Rewards of the tribe keep users coming back and wanting more.

Image result

2.Rewards of the hunt: 

Cut the crap version: We love to search for resources (money, food, information, deals  etc)

We are excited by the thrill of the hunt.

Hunt  for  variable  material  rewards

What several centuries back used to be a hunt for food, animals, shelter has now translated into a hunt for things like money, fancy objects, information and deals.

Image resultImage result for casino slot machineImage result

Some examples,

  • Hunt for money‚Ää‚ÄĒ‚Ääthink slot machines
  • Hunt for deals‚Ää‚ÄĒ¬†The Great Indian Sale on Amazon, discount sales in retail stores
  • Hunt for information‚Ää‚ÄĒ‚Ääscrolling across your twitter feed, google search etc


3.Rewards of the self

Cut the crap version : We pursue self-achievement

Image resultImage result for rubik cube

These are rewards that satisfy our intrinsic need for personal excellence and a sense of competence. Basically our brains are always on the look out for new challenges to overcome. The more success we have, the happier we are.

Some examples,

  1. Video games
  2. Playing a sport

In fact there is a new concept called Gamification which involves applying game mechanics and game design techniques to engage and motivate people to achieve their goals. This is extensively used in most of the apps.

 “In every job that must be done there is an element of fun.
   Find the fun and snap!
¬† ¬†The job‚Äôs a game.‚ÄĚ
                                              РMary Poppins, the 1964 American musical fantasy comedy film

Summary:

Most of the habit forming apps combine the three types of variable rewards, thereby increasing their effectiveness in creating user habits.

As I had mentioned earlier, there are few other steps which the app designers combine along with variable rewards to get the habit formation in place. I will talk about that in my next post.

PS:

If you like the content, it would be awesome if you could¬†drop in your comments and also consider¬†subscribing to the blog (all¬†posts shall be delivered directly to your inbox), because your valuable¬†comments and subscription are my variable rewards ūüôā¬†

If you have survived me till here, thanks a ton for reading and happy investing.