Are you familiar with the famous Marshmallow Test performed in the 1960s by psychologist Walter Mischel? He designed a simple experiment at Stanford’s Bing Nursery School to test the self-control of preschoolers. He put them into a room (filming it with hidden cameras) and told them they could either eat one Marshmallow immediately, or if they could wait until he came back in a few minutes, they would then get another one, for a total of two. The promised treats were always visible and the child knew that all she had to do to stop the agonizing wait was ring a bell to call the experimenter back—although in that case, they would not get the second treat.
A few years later, Mischel performed follow-up studies on the kids who participated in the Marshmallow Test. To his surprise those who were able to delay gratification long enough (to get also the second treat) did better in just about every facet and stage of their lives than those who gave in to temptation. The longer a child delayed gratification, the better he or she would fare later in life according to numerous measures. The child would performed better academically, earn more money, and was healthier and happier. They were also be more likely to avoid a number of negative outcomes, including jail time, obesity, and drug use. Mischel has since travelled around the world to study delayed gratification in various cultural and socioeconomic contexts. The principles from the marshmallow test seemed to hold universally.
What does this have to do with investing?
A key prerequisite to being able to invest like a professional is having the discipline to adhere to a pre-defined investment plan or strategy that has a positive expected outcome. This type of discipline is particularly difficult during periods when your plan or strategy seems to have temporarily stopped working, as no strategy works all the time.
Therefore, if you find yourself in a situation down your investment road where you just cannot stand the pain of a temporary underperformance: Think about that second marshmallow! Imagine you are one of those kids knowing it pays off to wait and have the discipline to stick to your investment plan to finally get the second marshmallow in the form of a potential outperformance.
The fact that we live today in a world of instant gratification does not make it easy to exercise this important skill in daily life. Particularly since the negative consequences typically do not show immediately, be it gaining unwanted weight due to undisciplined eating or piling up consumer debt for stuff we actually don’t necessarily need. The result is that our modern life, with all its choices and distractions, often feels like one continuous Marshmallow Test.
Do Mischel’s results mean that those who have not mastered self-control by pre-school have no chance? Thankfully not! Mischel’s follow-up studies also show that learning and practicing certain techniques and skills can improve self-control, giving hope to those of us not born with an iron will.
Mischel recently released a book called The Marshmallow Test: Mastering Self Control, which reviews what science has learned about self-control since that first Marshmallow Test over 50 years ago.
I believe that the financial Marshmallow Test for adults has two important components:
1. Saving/investing (for retirement) at some cost of today not consuming all you earn and
2. Investing that money with a good investment strategy that you stick to.
This can provide you with not only two but many Marshmallows over the years due to the mathematical magic called “compound interest” which means earning additional interest on interest.
“Compound interest [profit] is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
In our investment sense “interest” also includes profits (capital gains) from buying low, selling high. Basically, once you earn your first interest payment (or profits), it is added into the principal and this increased principal will allow your money to earn even more money over time. Albert Einstein said: “Compound interest [profit] is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
In a similar fashion, each of us has the possibility to use the right tools to create a marshmallow multiplying machine of our own. However, saving for retirement requires us to exercise the self-control to not eat all the marshmallows we earn, but to put some aside for later. This is essentially the same problem the preschoolers were forced to confront, but with a much longer time horizon.