Category Archives: Behavioral Finance

We all know that temperament is one of the most important quality not only in the investment field but also in our life. If we work on our emotional biases then we can win any battle. To excel in temperament, first, we need to be aware of the various biases. So now onwards, I will illustrate various biases and how we can excel it and use it in our life. This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly”.

BUILD YOUR OWN CASTLE Envy

Posted on by under Behavioral Finance

Many things spark envy: ownership, status, health, youth, talent, popularity, and beauty. It is often confused with jealousy because the physical reactions are identical. The difference: the subject of envy is a thing (status, money, health, etc.). The subject of jealousy is the behavior of a third person. Envy needs two people. Jealousy, on the other hand, requires three: Peter is jealous of Sam because the beautiful girl next door rings him instead.

Business – when the product of any company meets success then peers feel envy which leads to a faulty decision. The faulty decision will lead to financial disturbance.

Investment – When our fellow investor has able to earn good returns that will make us envious of his success. This put us under pressure and we ended up doing some nonsense things which will result in wealth destruction.

How do you curb envy? First, stop comparing yourself to others. Second, find your ‘circle of competence’ and fill it on your own. Create a niche where you are the best. It doesn’t matter how small your area of mastery is. The main thing is that you are the king of your castle. By looking at other castles, people generally burn their own normal homes. So be careful with decisions and emotions getting born due to envy.

This entire series will be reviewed with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

THE DIFFERENCE BETWEEN RISK AND UNCERTAINTY Ambiguity Aversion

Posted on by under Behavioral Finance

The Ellsberg Paradox offers empirical proof that we favor known probabilities over unknown ones. We stay away from uncertainty and try to give higher weight to known things. Risk means that the probabilities are known.

Uncertainty means that the probabilities are unknown to us. We can make calculations and decide either making bet or not while risk involved. But when uncertainty comes, we cannot make any calculations so decision-making becomes harder.

Only in very few areas where we can count on clear probabilities: casinos, coin tosses, and probability textbooks. Often, we are left with troublesome ambiguity.

Investment – We generally mixed up when we think about risk and uncertainty while investing. We tend to keep saying that we get higher returns where the risk is higher. But actually, we get higher returns where uncertainty is higher. When things started getting certain, valuation starts reflecting certainty, and chances of making good returns reduce.

COVID-19 pandemic is an uncertainty rather than a risk, and we can see that return comes after the pandemic event.

This entire series will be reviewed with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

WOULD YOU WEAR HITLER’S SWEATER? Contagion Bias

Posted on by under Behavioral Finance

The contagion bias describes how we are incapable of ignoring the connection we feel to certain items – be they from long ago or only indirectly related (as with the photos).

When we have faced some events in life and if anything related to those events comes Infront of us then we cannot ignore it and cannot stop reacting. Connection in our minds comes alive and we start getting disturbed.

One person has cheated on me a long back but when I met a family member the person, I cannot ignore the connection between both the person and I became rude in conversation.

If we have made an investment in any stock and have incurred a loss, then that sector, management, valuation, or anything will stay in our mind. When we meet up in a similar situation then our mind again lives that connection that impacts our thinking and decision making.

We heard that companies that originated from particular cities have a higher probability of wealth destruction. When any investment opportunity comes in front of us from similar cities then we used to ignore that opportunity without doing proper research on it.

So that we need to prepare a checklist for every stock, every time. If a stock is passing that checklist, then we must invest in it rather than getting biased from any past events.

This entire series will be reviewed with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

BE WARY WHEN THINGS GET OFF TO A GREAT START Beginner’s Luck

Posted on by under Behavioral Finance

At some point in your life, you’ve won a game you’ve never played before or witnessed a young child say or create something with worldly depth. These are both examples of events we attribute to something called beginner’s luck as if chance caused them to happen. – Lifehacker

Investment – When someone starts investing and he has reaped good returns on the initial investment. Then he starts thinking that he pursues an above-average skill and knowledge which has rewarded him well. This is known as beginner’s luck and that makes novice investors blind to making wise decisions and efforts.

The stock market always checks novice investors with beginner’s luck and those who can come out of the trap, can have a better chance to survive further. We should focus on long-term success rather than one year or a month of success. Sometimes, novice investors earned an above 50% return on their investment and they start thinking of themself as talented as Mr. Warren Buffett. Nowadays, one-two correct bets promote them from analysts to fund managers. They started to manage the funds of family and friends.

We should understand that the stock market is a sea and, we need to have remained lifelong students to walk in the depth of the sea. Not a master, because the master is always a market.

We should not get excited by one or two of success but have to remain grounded by focusing on long-term success. If we keep meeting success during a longer horizon then we can consider ourselves mature investors.

This entire series will be reviewed with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.