Behavioural Finance series summary

For the past one week, I have been writing about the various biases, fallacies and tendencies of people when it comes to money and investing. If you missed them, here are the links to the posts.

  • Anchoring Bias – The first number or information you see plays an important role in the decision you make and will be close to that number.
  • Loss Aversion and Sunk Cost Fallacy – The tendency to make decisions so that to avoid incurring losses (even as low as 1¢).
  • Confirmation & Hindsight Bias – You will always favour information that suits your beliefs or investment and hate seeing the opposite view even if it is the truth.
  • Gambler’s Fallacy – The feeling you get that you will definitely win this time or the stock has been falling down for a long time that it will soon turn around.
  • Overreaction and Availability Bias – Any event that is fresh in your memory affects your decisions, causing you to overreact to the news – be it good or bad.
  • Regret Aversion Bias – Fear of regret from any decisions causes you to miss a lot of opportunities and also lead you to make worser choices.

These are not the only biases that affects us. There are many more and the field of Behavioural Finance and Psychology in Money is vast. Check out the list of Cognitive Biases that affects us in general.

Always remember that you are not special. Every human is susceptible to these biases and the only way to avoid them all is to use critical thinking and not taking decisions in a hurry. Identify these biases, apply your knowledge and you are sure to become a better investor than most others.

Behavioural Finance: Regret Aversion Bias

Have you ever felt that a company is doing good business and wanted to buy the stock, but waited for a drop in price. And the stock never came down, you never invested and gave manifold returns only on paper. Didn’t you want to kick yourself because you failed to grab the opportunity? Why did you do it?

You know you did your analysis and found a good stock. But you were doubtful if you made the decision and the stock instead went down – you would regret having got in such a high price and sitting at a loss. The fear of regret made you not make any decision and making you miss it.

Some times we would have got in a stock at a very low price and would sit on nice profits. You would now get anxious whenever it closes red even for a day. You then decide to get out of the stock taking how many ever profits you got. After you are out of the stock, it continues to go up and give more than double the money you would have invested.

All these are called the “Regret Aversion Bias”.

Examples from my life

I have examples in my own investing life for both the types. I wanted to buy MRF which was trading at Rs.10000. I felt that it was too high and wanted to wait for a few days for it to correct a bit. It didn’t and in over a year it more than doubled the investment. A good stock, but because of my fear of regret, missed the opportunity.

Another example when I invested in Idea Cellular. The markets tanked in 2008 after I bought and I held it for more than a year or two. It reached my cost price and even gave me 10% returns. As I was very new to investing and already burnt by the bear market wanted to get out of it with at least the 10% profit. I did get out, but now I hate myself for missing the opportunity to hold the stock and get more than double the returns.

How to avoid this bias?

Before you make an investment decision spent enough time and resources to analyse the company. Its OK even if it takes an extra day or two. If it is a good company with good fundamentals, a few rupees of difference in your cost price wouldn’t matter much. Once you are sure that it is a good company and decided to invest, don’t wait forever to invest. Get in the stock and stay invested. If it corrects, you can average it, provided it is still fundamentally good.

Second important factor to remember is to not get out of the stock just because it gave your 10% or 20% returns. Try to ride the wave and see how long till it tops out. You will be more profitable waiting for a stock to top than get out every 20%.  Understand your risk taking ability and also make sure that your risk-reward ratio is favourable.

Behavioural Finance: Overreaction and Availability Bias

You travel on a particular road to work everyday morning and yesterday you saw an accident happen right before your eyes. What would your reaction be? You will begin driving carefully. Even if you don’t if you tell your family or friends about it, they would advice you to be careful on the roads.

Has the number of accidents increased suddenly? No. It is the same for the past few years. They should have advised you long time back and not just after the accident you saw. Why is it? Because of something called Availability Bias. People tend to judge things and act based on the most recent information – be it news that really happened or even opinions of others which might be false. After a few weeks have gone by, you would go back to your original driving style. As long as the event is fresh in your eyes, you would try to act based on that.

How does it affect investors?

Whenever some bad news comes out about a company, everyone tries to get out of the sinking ship as quickly as possible. This causes the stocks to fall to dangerous levels. But in real the bad news might not be that bad to cause such a huge percentage fall in prices. This works equally well for the good news too. All investors want to get in the stock based on the latest good news and drive up the prices more than its value. This is completely opposite of the Efficient Market Hypothesis – at least in the short-term.

There has been a research done on stocks in the New York Stock Exchange, where they picked 35 good stocks and 35 bad performing stocks into two portfolios. Over a 3 year period, they found that the bad stocks portfolio consistently beat the market index and the “good stocks portfolio” consistently under performed.

This shows that investors overreacted to the bad news and drove the stock prices down a lot. Similarly they overreacted to the good news and drove the stock prices all the way up. Over a long time period, this averages out and the real value of the stock comes out.

Overreaction

This affects not only investments in stocks, but also people buying Mutual Funds or ULIPs because the agents showed how big the returns were in the past.

How to avoid Availability Bias?

As always do your own analysis and research before making any decisions. Don’t listen to the talking heads in the various financial TV or media. It is usual for the media to over-hype things because that is what gives them money. Remember never make investment decisions when you’re emotional. And remember what all Mutual Fund companies say at the end of their advertisements? “Past performance is not an indicator of future performance”.

Have you ever overreacted to any news and realised later that it was stupid? Leave your experiences in the comments below.

Behavioural Finance: Gambler’s Fallacy

Coin TossIf you and your friend has a bet on coin flips and for the 10th consecutive time (you are using a fair coin), you called out “heads”, but you lost, what would your thoughts be on the 11th toss?

“I have lost 10 times in a row. I am definitely going to win this time.”

Isn’t that what any normal human would think? But what does laws of probability and Math say? Each coin toss is an independent event and the probability is exactly 50-50. It doesn’t matter if it falls tails for 10 times or 100 times, the next toss can either turn out to be a head or a tail, in exactly 50% probability. But normal human mind doesn’t think about probability and math when he thinks “This time it I will definitely win”. It is the irrational mind that makes you think in such a way.

This is what is called Gambler’s Fallacy. This is more commonly seen in the slot machines, where people keep putting in coins after coins, thinking they are close to hitting the jackpot. When in reality the probability is the same on every coin they put. The machine is designed to payout in a particular ratio of winnings only and playing more doesn’t increase your chances of winning. Side Note: You will definitely lose more than you win in any slot machine.

Gambler’s Fallacy in Investing

This is widely seen in the field of investing/trading and many would have fallen in this trap. They would see a particular stock falling from Monday to Friday for 5 days straight. They would immediately think, the next trading day it will surely go back up and I can make a quick profit. Let me go buy now and sell on monday.

They fail to understand or analyse why the stock has been falling for 5 days – it could be numerous reasons like, policy decisions, competitors, losses, higher debt, corporate governance issue, etc. Without knowing the details of the stock movement, no one can predict when the stock will stop falling. It is foolish to think that the stock has nowhere to go but up. But numerous investors think like this and buy into worst possible companies and lose all their money.

How to avoid it?

First you need to understand that in any independent event, the odds of any specific event or outcome is the same regardless of how many times it has happened in the past. This is even more important in stock market because there is too much external noise and you wouldn’t even think clearly because of all the high volume trading.

Never buy a stock just because you “feel” that the trend has been downward for too long and will reverse any moment now. Always decide after doing sufficient fundamental or technical analysis before investing in stocks. Its better to wait till it goes upwards with a confirmation even if it means losing a few rupees than to hastily invest before it has reached a bottom.

Behavioural Finance: Confirmation & Hindsight Bias

Confirmation Bias

Fundamental analysts or people who believe such reports need to be aware that they might be under the influence of Confirmation Bias. This is the tendency of people to favour information that confirms or matches their beliefs.

Lets say you are the ardent supporter of a political party. You would see that there are more and more news articles that confirm your views about how the party will win the majority in the elections or how the leader is the best thing to happen to India, etc. If your friend supported the opposite party, he would see more articles supporting his leader/party.

This doesn’t apply just for individuals, but also to organisations or even governments. They keep searching for information which supports their theory and would hate anyone who would say otherwise. They would even say the opposing view is false and wouldn’t believe it.

How does it affect Investors?

We as investors are heavily affected by it, especially if you base your investments on someone else’s analysis. Numerous analysts publish reports about stocks and why it is a good investment strategy. Once you made your decision to invest in a stock, you would look for reports and news which support your decision.

You would read how all analysts are taking how good the company is, how cheap the valuations are, etc. You would go out of your way to prove that your investment was the best decision, even though the company might not have customers or revenues to match the high price.

HindSight Bias

Hindsight is 20-20You know how they say hindsight is always 20-20. This is also called the I-knew-it-all-along effect. After a disastrous event has occurred, you would see many people proclaim that they knew it was bound to happen all along, even though there was no way they would have predicted it.

There were numerous bubbles in the history – tech bubble, sub-prime crisis, even the tulip bubble. Every time after the event numerous experts came out saying “We knew this would happen all along. It was just a matter a time.”

In stock markets, this could be very dangerous as it makes the trader/investor to feel overconfident. When you keep picking numerous stocks which gives you good returns, you would soon believe that you have superior stock-picking skills.

Avoiding these biases

To avoid both these biases, it is important that you realise that what you read is not always true. If you want to invest in a particular stock, instead of reading reports and articles that praise the stock, try searching for negative reports. Actively look out for reasons which would make you not to invest in it. Be the devil’s advocate and then invest if you still think its a good stock.

Have you ever had a similar situation where you knew or believed that you predicted something would happen? Tell me more about it in the comments below.

Behavioural Finance: Loss Aversion and Sunk Cost Fallacy

Have you even gone to a buffet lunch/dinner, found out that the food was very bad, but ended up eating your fill anyway?
Or unknowingly bought an uncomfortable pair of shoes and kept wearing it even though it was painful?
Did you ever sit through the most boring movie of your life, because you spent money for the ticket?

I know most of us have had experienced something similar and we all have been victims of the Sunk Cost Fallacy. Sunk cost is a retrospective or past cost that is been made into a business or decision. But before we try to understand sunk cost fallacy lets see something called “Loss Aversion”.

Loss Aversion

Loss Aversion is the strong tendency that people have that makes them to avoid incurring any loss. We are more wired to avoid losses than to acquire gains. The amount of loss doesn’t matter, it is the feeling of losing something that counts.

There was an interesting experiment done by the Behavioural Economist Dan Ariely who setup two booths where people could buy chocolates. There were two kinds of chocolates – Hershey’s Kisses and Lindt Truffles.

  • In shop 1, Kisses cost 1 cent and Truffles cost 15 cents, which is the usual price you could buy them elsewhere.
  • In another shop 2 (setup a bit far away from shop 1), the price of both chocolates was reduced by 1 cent – so Kisses was given free and Truffles cost 14 cents.

In the ideal world, there would be no difference to the number of chocolates sold in both the shops, as the difference between two chocolates is always 14 cents. But in the real world, there was a very notable difference. In Shop 1 (where both chocolates cost some money), people preferred buying Lindt Truffles as it was a better chocolate and they wanted to enjoy it. In Shop 2 (where Kisses was given away for free), more people picked kisses than they bought the Truffles.

The reason was, people’s Loss Aversion instincts kicked in. They saw that a chocolate which usually costs 1 cent is now free and they would be a fool to not accept that offer. In other words, they thought that they are losing money because they didn’t pick the free chocolate.

This is the reason, many shops entice their customers with free gifts, free shipping, unbelievable offers, etc. When you want to buy a gadget from two competing stores, you would be willing to pay even a few hundred rupees extra if one of the shops offered a freebie with the product – because your loss aversion instincts kicks in.

Sunk Cost Fallacy

This loss aversion instinct is what leads us into Sunk Cost Fallacy. A Sunk Cost is money or time you have investing in a project or investment already and which cannot be recovered.

Lets say you wanted to surprise your spouse and bought tickets for your summer vacation and have already spent Rs.10000 for the travel and stay. Your spouse wanted to do the same and planned a vacation to a different place and spent Rs.5000 for the tickets and stay. Finally you both find out that the dates are overlapping and the travel agent says that the money is non-refundable. Which trip would you go with? When a bunch of people were asked in a study, more people chose the costlier trip.

If you think about the reason, it is quite simple. Both the money spent is a sunk cost (money that cannot be recovered). Since you can go to only one trip, you wanted to minimise your losses. You thought that losing Rs.5000 is much better than losing Rs.10000, even though you might have enjoyed the cheaper trip. This sunk cost fallacy makes us do all sorts of stupid mistakes without even realising it. Even big governments with numerous experts and economists are prone to this – which is why they keep building many projects which are not financially profitable.

Personal Finance and Sunk Cost Fallacy

Now how does this fallacy affect us in personal finance and investing?

  • We all know Term Insurance is the best insurance than the traditional Endowment/Money Back Policies or even ULIPs. But we would have taken a few traditional insurance policies and we keep paying more money in it, even though we know the returns will be less than 6%. Because we have already invested for 3-4 years and its a sunk cost. Surrendering the policy means getting out at a loss. So we keep paying for these useless policies (including me).
  • We would have invested in many stocks and in a bear market when everything falls down, we would still be thinking “No No. These stocks are good and it will come back up at least to the cost price. After investing so much in it, selling now will be a loss.” This is even more dangerous if the stock is falling because of a fundamental problem and the investor thinks “The prices look so cheap. Let me buy more and average my price.” Just because we invested money in a stock we shouldn’t expect it to rise. Worst cases, it is better to book losses and shift that money to a different stock to get back your capital.
  • When it comes to Personal Finance, people spend more money repairing old appliances like washing machines, water purifiers or even their first car. In most cases, it would be cheaper to replace the unit instead of trying to repair it and source spare parts for it. I am not saying you should throw it out at the first sign of repairs. But when you keep trying to repair something which is older than you can remember – not worth the money.

How to avoid it?

  • If an investment doesn’t go the way you thought, admit you made a mistake. Cut your losses and exit. Try to preserve the capital, so that can be invested in a better opportunity elsewhere. You can recoup the losses and even make a better profit.
  • Check for opportunity costs. Instead of keeping your money in bad investments, switch it over to better investments.
  • And as with other fallacies or biases, try to be as rational as possible, think critically, analyse and evaluate before you make any decision.

Behavioural Finance: Anchoring Bias

The first cognitive bias we will see in behavioural finance is “Anchoring” or also called “Focussing”. It refers to the common tendency to rely too much on the first information we hear whenever we make any decisions. Imagine you want to sell your car and a mechanic comes to your home and looks at it.

Mechanic: Sir, I can give Rs. 1 lakh for it.
You: What? No can do. I bought it for Rs.4 lakhs and it is just 3 years old. Rs.1 Lakh is too low.
Mechanic: There is already an history of accident and I need to spend at least  Rs.50,000 more on repairs.
You: Oh come on. Can’t you at least give Rs.1.25 lakhs?
Mechanic: Ok. Deal.

Now what happened here? The mechanic started off by giving the number first and you were “anchored” to that price. If he didn’t start at a number, you could have gotten at least 1.5 to 1.75 lakhs for the car. Since he stated the number first, your mind immediately fixed at that and couldn’t go more than 25% of that number.

Even though its an imaginary conversation, you would have had a similar experience in various situations – salary negotiations, bargaining something you want to buy, getting a loan from your bank, etc.

This anchoring effect has been proven by researchers in various situations. Many times they were surprised with the results, because the anchored number had nothing to do with price – e.g.: last 2 digits of a SSN (Social Security Number), random numbers from 1-100, etc. Any number you see will affect the price you are willing to give for a product. But did you know that this effect is also seen in the world of stock market investing or trading? Yes, you as an investor will lose more than you could gain because of this effect.

Anchoring Bias in Investing/Trading

Lets say you bought 100 numbers of a share at Rs.100 (Investment of Rs.10,000). And the stock had a nice bull run and after many years it made a high of Rs.500 per share. Nice profit of Rs.40,000. But since stocks are volatile in nature, it too will come down. Lets say today the stock is priced at Rs.400 per share. Would you sell the stock and book profits?

If you said “No way. Do you want me to sell at a loss? This recent down trend is temporary. It will go back up to Rs.500 and even more.”, you are a victim of the anchoring bias. You saw the high of Rs.500 per share and the thought of selling at Rs.400 meant it is a loss for you. Even though you are sitting at a nice profit of Rs.300 per share, the Rs.100 you missed is what you remember.

Anchor Point

This can work the other way around too. Lets say you bought a stock at Rs.500 and the stock falls continuously and settles at Rs.100. Most amateur investors will immediately look at this as an averaging opportunity and buy more of the stock. Their reasoning is compared to the Rs.500 per share, Rs.100 is a bargain price. They are anchored to the Rs.500 price.

They won’t research on what made so many people to sell the stock. There could be a fundamental problem with the company like loss of revenue, lot of debt, heavy competition, decreasing customers or order books, etc. If that were the case, there is no use in averaging the stock and it would only lead to more losses. There have been numerous examples like Suzlon, Educomp, KingFisher, etc., where numerous investors have lost lot of money.

How to avoid Anchoring Bias?

The only way to avoid this effect is to think rationally and critically before making any decision. In order to think properly, you would need as much of objective information as possible about the situation – be it negotiating your salary, your car price or investing.

If you are negotiating your salary, make sure to get lot of information about the role you are filling in.
If you are negotiating a loan or buying a car, just forget the first number they other guy says try to think objectively and come to a number you are comfortable
If you are investing, don’t just go with the prices of stocks, but learn to do fundamental analysis on the company and analyse why there has been such a heavy loss. Don’t jump in and buy stocks just because it looks cheap.

A few minutes of critical thinking wouldn’t cost you too much – in fact you can gain more than you lose if you can remember the anchoring bias. Next time you are negotiating something, try to remember who made the offer and how much you actually expected to get before hearing that offer. Read more from Wikipedia.

What makes humans irrational when it comes to money?

Economists for a long time believed (at least wanted to believe) that humans are rational when it comes to decision-making about money, markets and overall economy for that matter. These economists thought that, given two choices, a normal human will take the most rational or profitable decision for himself. But in reality things were different.

Psychology plays a very vital role in how humans perceived money and the value of something they are buying. This caused them to give more money for cheap products or very less money for really valuable things. This is also the main reason we can see so many volatility in the markets and affects how investors or traders make money. This is also the reason why people buy so many things which they don’t have any immediate use for or won’t throw away things that they have never used at all.

Behavioural Finance

This study of combining human psychology and economics is called as Behavioural Finance. Lot of people have researched about behavioural finance and have also conducted numerous experiments to prove that we aren’t as rational as normal economists think we are. Easiest proof you can see is people who buy lottery. Even though they know that the probability of them winning is 1 in Millions, they still buy it hoping they will turn out to be lucky.

Starting from tomorrow, I will be writing a mini-series of posts for the entire week, about the various cognitive biases and fallacies that humans face when it comes to handling money and how it affect their investments or trades.

  • Why it is very hard for someone to book losses and get out of a trade?
  • How we are not ready to lose something that we have owned for some time.
  • Why we can only see news which supports our own views and how it affects our investments?
  • Why everyone likes status-quo and don’t want to change?
  • … and many more of such biases

It is going to be an interesting week ahead. Make sure you subscribe with your email address below, so that you don’t miss any article.

Discounts on Magazine Subscriptions – How do they work?

When I said yesterday that I subscribe to lot of magazines, there was a thought that crossed my mind. How do these magazines make a profit after giving such deep discounts when  you subscribe them? You must have seen them right? A copy which costs Rs.100 on the stands, you can subscribe to it for Rs.1080 for a year – or Rs.90 per copy. Subscribing to 3 or 5 years, further reduces the price. How are they able to give such discounts?

magazine subscription

To understand that, you would need to understand the time value of money. If I asked you “Do you want Rs.1000 today or Rs. 1000 a year from now?” What would your answer be? “Gimme the money today” right? Why? Because the money you get today is more valuable than the same money you will get in the future. Assuming a bank gives me 10% interest, you can take my money, put it in the bank and get back Rs.1100 in a year.

Now after understanding that, if the question was “Do you want Rs.1000 today or Rs.1100 a year from now?” Even if you invested in a bank you will get back Rs.1100 after a year. So there is no difference in getting the money today or a year from now – at least mathematically speaking.

But humans are not rational beings. Whenever I ask this question to my friends, I always get the answer “Better get it now. I am not sure what would happen in the future. What if you don’t give it to me?” The reason is: Certainty. What did we learn when we were kids? “A bird in hand is better than two in the bush”.

That is exactly what the magazine company also does. They give a reduced price for the same magazine, but your money is now in their bank. They can invest it or use it later and they are certain that you are locked into the subscription for the year. If you calculate the discount it would mostly match what a bank gives or even less than that. This same calculation holds true for the longer terms like 3 or 5 years. They may advertise it as 15% or 30%, but if you calculate the annual rate of interest it would be almost same as what you get in a bank.

So it doesn’t matter if you buy it every month from the stands or subscribe to it and get it for a year, you are not losing much. I would suggest subscribing – for the comfort of getting it delivered directly to your house.

So if you find a magazine that is not giving you any discounts for subscription, should you not subscribe? I would say “It depends, but I would subscribe even in that case.” If you look at it strictly on a mathematical sense, you are making a loss, but look at it from the comfort point of view. Not having to remember to walk down to the nearest newsstands every month, hoping they carry that magazine and instead if the company delivers it right down on my doorstep – I would pay for such a comfort. That is a fee that I am ready to pay.

Two things you should spend your money on

Read any personal finance site or expert’s opinions, you are sure to see the following:

you should save your money.
reduce your expenses.
make sure you spend less than you earn.

Well, I agree that this is good advice, but only if people follow it. Human brain is highly irrational, especially when it comes to money and you might want to buy certain things that make you happy. Your friends might call them as your weaknesses. These might be something as simple as lots of stickies or a nice pen or that expensive notebook that you never will use more than 2 or 3 times, etc. (btw, these are all my weaknesses).

It need not be so silly, it can be a weekend out-of-town with friends, nice candle light dinner with your significant other, a nice smart phone when your old one is broken, etc. These are things that are expensive, but gives you more happiness and joy than the money you spend. Just imagine going to a movie with your family/friends and then eating out – everyone enjoys the day and sleep happily. Sometimes such memories will stay with you for a long, long time.

Buy things that make you happy.

There are also other types of things which I would say are very important that you spend your money on – investing in yourself. No, this has got nothing with money, interest, inflation, etc. It is the things that you learn from others and which will make you better in your professional and/or personal life in general.

It could be books that you buy and read, the Yoga class you joined, Gym membership to keep yourself fit, even getting high quality dresses for your office, etc. If there was one thing that my dad didn’t think about buying for me was “books”. Whatever book I ask, he would get it for me – and the things I learnt from it surpass any returns that he would’ve gotten by putting that money somewhere else.

Other things that I have invested in is my health trying to get fit, books/magazines that I read and then online courses. I have joined a few online courses, about investing, self-improvement, entrepreneurship, etc. The few tens of thousands of rupees I spend today if it helps me in earning even a lakh in a year, is a great investment.

Invest in yourself.

There are other things doesn’t improve you personally, but are equally important. For example, if you are an entrepreneur, it could be a lawyer you hire to set up your company, the accountant who understands all the financial things better than you do, etc. All these are not expenses, but investments that you do for your business or yourself. If you are just another salaried person, one important investment you could make is getting the help of a good financial planner.

I know way too many people who were mis-sold investment products and who don’t know the difference between investment and savings. Even I was in a similar situation and decided to learn things from books and the internet – but if you are not interested in starting from the basics, you would do well by hiring a good financial planner. Remember your insurance agent isn’t a financial planner.

So remember these two things which you can and should spend your money on:

  • things which makes you/your close ones happy
  • things which will improve your personal/professional life in the long-term.