GetRicher.in

Behavioural Finance: Anchoring Bias

by 1 Comment

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?

by Leave a Comment

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?

by Leave a Comment

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

by 1 Comment

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.

Diversification – How to do it and how not to do it

by 3 Comments

Lot of people don’t understand the need for diversification. If they did, they wouldn’t go and buy houses or land spending tens of lakhs of Rupees, being in debt for 25-30 years paying EMI. I am not against getting your own home to live in, but there are people who think real estate is the best investment and keep buying more houses, believing they can get rental income from it.

These are the people who have more than 80% of their net worth in real estate. If it is not real estate, it will be gold or fixed deposits. I don’t have a problem in investing in different asset classes, I even suggest that you should spread your money in different investments. That is what most of the financial planners also say.

How you split the investment should be based on your long-term goals and not how many apartments or gold jewellery your neighbour or relative has. If you are a young investor, you should have majority of your investments in equity and a very small amount in debt/gold. If you absolutely need to buy a house for living, remember to also invest a sizeable amount into equity, so that you begin saving enough for your retirement or your kid’s education.

Diversification in Stocks

The concept of diversification can be applied to individual stocks or sectors too. If you invest directly in equities and you keep buying just one specific share, you are putting all your eggs in that particular company. If that company faces a problem, no one can save you and all your capital can be erased within a few days.

But you may say that you invest only in large cap stocks and these are the companies that can never go down, right? Wrong. Have you heard of Satyam? Hindustan Motors? and literally hundreds of such big companies that tanked either in a few days or over the years. Anything can happen to any company at any time. In the case of Satyam, it was the problem with the Chairman and in case of Hindustan Motors they failed to innovate and it is almost wiped out.

Diversification in Sectors

So, now you may say, “Ok. Instead of buying just one company, let me buy all the companies in a particular sector.” That is also equally risky. Whenever bad luck comes, there is a high possibility it comes for the entire sector. Public sector companies, real estate, infrastructure, sugar are some of the examples that are down for many years now. If you invested in a single sector – say real estate, you would have gotten zero returns or even negative returns overall.

When a particular sector like real estate gives you negative returns, there will be other sectors, like Pharma or IT till 2013 which outperformed. Collectively all these sectors would save you from any adverse effects of a particular policy decision (or lack of) in a sector – like sugar or mining or power. That is why you should always spread your investments across sectors.

Diversification in Size

This is also important. You can play safe and invest in only large cap stocks. But large cap stocks can only grow unto a certain limit. If you need returns more than that, you would have to invest in mid-cap or small-cap stocks. While they are more risky and can be more volatile than large-cap stocks, in case of a bull market, they can give you much higher returns on your portfolio

Mutual Funds to the rescue

Now for a retail investor to analyse the thousands of stocks and the various sectors’ movements and market cap can be impossible. Also to track this every month and rebalance his portfolio is simple unthinkable. Now this is where mutual funds are going to help you. Investing in mutual funds gives you all the benefits of diversification and none of the headaches associated with analysing it.

Since Mutual Funds automatically invest in numerous stocks (typically 30-50 stocks) split across sectors and are also categorised based on the Market Cap of the companies it invests in – it is the easiest solution one could think of. All you need to do is pick the right mutual funds and you can just keep investing in SIP and just track the performance of the fund instead of individual stocks. Performance of individual stocks is something you leave the fund manager to worry about.

Diversification in Mutual Funds

Diversification is good right? So should you go invest in 10 or 15 mutual funds and enjoy the safety? There are people who do this too. I have seen people who are investing in 10-15 mutual funds – they feel happy that their investments are protected. This is the most dumb rookie mistake and if you think even a teeny-tiny bit what happens you would understand.

When you invest in a large-cap fund (A), what does the fund manager do?
He chooses the best 30-50 stocks from the universe of about 200 large-cap stocks and puts your money into them.

Now lets goto large-cap fund (B), what does the fund manager do?
He chooses the best 30-50 stocks from the universe of about 200 large-cap stocks and puts your money into them.

Now lets goto large-cap fund (C), what does the …… (you get the idea?)

If you are going to invest in N mutual funds which has the same objective, you are not really diversifying. You are in fact investing in the same stocks over and over again, because there is going to be a lot of overlap. You are going to have even more headache because you now have to track the performance of 15 funds.

So, what should you do?

Diversification is needed in mutual funds, but it does no good if done blindly. You should diversify only across market caps and not across the fund houses or fund managers. All you would be needing is invest in

  • one large-cap fund
  • one mid-cap fund
  • one small-cap fund

For 99.9% of the investors who want to invest in balanced equity funds, this combination should be more than enough. The percentage of the split would vary depending upon your risk tolerance and the market conditions. If you need to diversify across asset classes, there are funds for that too. which will solve most of your problems.

Remember, Mutual Funds are designed to make your life simpler. Once you begin to micro-manage stuff, all kinds of crazy stuff comes out. So investors need to first understand about diversification – why you need to do it and when you don’t need it, before going and picking numerous stocks or funds for their portfolio.

>