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”.

EVERYONE IS BEAUTIFUL AT THE TOP Halo Effect

Posted on December 26, 2021 by Jimit Zaveri under Behavioral Finance

The halo effect occurs when a single aspect dazzles us and affects how we see the full picture. When we like something about some person then we start liking many things about them, also things which we may not observe about them. This is known as the halo effect.

When we meet someone and like him/her then slowly our emotions make more sense of liking various things of them which may or may not be observed by us. Or that may not be real. Reversely if we dislike the person or something at first impression then later on we tend to dislike more things about the same though it may be good.

The parable of the blind men and an elephant originated in the ancient Indian subcontinent, from where it has been widely diffused. It is a story of a group of blind men who have never come across an elephant before and who learn and imagine what the elephant is like by touching it. Each blind man feels a different part of the elephant’s body, but only one part, such as the side or the tusk. They then describe the elephant based on their limited experience and their descriptions of the elephant are different from each other. – Wikipedia

Investment – We see single elements to create an entire picture. Such has happened during the IT bubble and infra bubble. When prices of IT companies started rising, people think that IT is a new era, the world will be going to change and IT stocks remains shining forever. Same with infra, shortage of land, affordable housing, nuclear family, etc. But when the bubble got burst people started with different stories.

We should try to study all aspects in detail so that we do not make such mistakes of using one attribute as an entire story. If we have focused on one attribute and ignored others then we will be at a mercy of luck which might result in huge regret in the future.

Our first impression has a greater impact on our future perception of the same things. We should write down things which have an impression on our minds. And help system 2 to take charge. This makes us able to make a wise decision rather than fall into the first impression trap.

When we start with the company study and we found some liking features, later on, we like many things about a particular company. That may or may not be true. We have to be suspicious from starting and giving control to system 2. We can write down things that are making us biased and work on collecting disconfirming evidence. We should have worked on the scorecard method and given scores to every fact about the company. So that the end score can drive our decision rather than the halo effect.

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

CURB YOUR ENTHUSIASM Winner’s Curse

Posted on December 12, 2021 by Jimit Zaveri under Behavioral Finance

The winner’s curse suggests that the winner of an auction often turns out to be the loser. When we bid on something for winning it then over some time, we start buying things at a sky-high value and that will end up as losers.

Business – when businesses adopt heard behavior and they see other businesses start acquiring businesses. So, they also involve buying businesses at a higher price to win the competition. Businesses win other businesses for time being but due to the higher price paid by them, this bid will result in a troublesome situation in the longer term. We have seen lots of high-priced acquisitions made by businesses that turn out to be trouble creating for the core business.

Investment – IPOs, mergers, and acquisitions are part of the winner’s curse. As they offer the part to them who bid higher. So that winner gets stake of the company but the majority of the time, winner get it at a higher price and that ultimately losing things. During the regular buying of stocks, we have many buyers who wanted to buy a stock. So, one put a higher bid compared to others for buying it first so the last bidder comes as a loser. The current scenario is similar to the winner’s curse, with many high-priced IPOs floating to the bourse and people chasing it heavily. We don’t that many of those will survive in the future or not. And if survive then what will be the return going forward.

As Mr. Buffett has advised that we should not go for auction. If we have to go for it then first decide the maximum value then deduct 20% from it and do not bid a single penny on that deducted 20% amount.

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

WHY TEAMS ARE LAZY Social Loafing

Posted on November 28, 2021 by Jimit Zaveri under Behavioral Finance

The social loafing effect occurs when individual performance is not directly visible; it blends into the group effort. When there is an involvement of many people, individual performance will start reducing. Social loafing occurs when an individual is doing less when working in a group, as opposed to putting forth full effort if they were alone.

Social loafing has interesting implications. In groups, we tend to hold back not only in terms of participation but also in terms of accountability. Nobody wants to take the rap for the misdeeds or poor decisions of the whole group. If a team member feels their impact will not be worth much – especially in a large team – they may decide to back off and enjoy the ride at the expense of the others.

Investment – When a large group of people involves in the decision-making of an investment opportunity, and the decision goes wrong. Then no one will be ready to take responsibility. We should not involve large numbers of people in the decision-making process. And if large numbers of people get involved then we need to make sure that each person is accountable for their decision.

The disadvantages of groups can be mitigated by making individual performances as visible as possible. Reward and punishment for each member of a large group can help to reduce the effects of social loafing.

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

WHY THE WHEEL OF FORTUNE MAKES OUR HEADS SPIN The Anchor

Posted on November 14, 2021 by Jimit Zaveri under Behavioral Finance

When We start with something, then we are getting sure of it and venture into unfamiliar territory from there. When we have a problem and we do not know the answer then we start thinking of what we know about the problem and then start moving towards the answer. By this, we can reach approximately nearer to answer.

If you consider how much you should pay for a house, you will be influenced by the asking price. The same house will appear more valuable if its listing price is high than if it is low, even if you are determined to resist the influence of this number.

Our mind makes some number or information as a base and makes further decisions. This effect is known as an anchoring effect. People adjust less (stay closer to the anchor) when their mental resources are depleted, either because their memory is loaded or because they are slightly drunk. Insufficient adjustment is a failure of a weak or lazy System 2.

When we go for a bargain while purchasing products/services then we got anchors with the initial listing price by the seller.

We also get anchored by numbers. When we have seen some product/service which values at Rs.10 and then if that things available below it then we rush to buy it by considering it has become cheaper.

The selective activation of compatible memories explains anchoring: the high and the low numbers activate different sets of ideas in memory.

The situation in which we are that priming to anchoring to specific numbers. For example, if someone asks us the average temperature of India and the answer is very with whether in which we are. Summer will tend to bring average temperature answers to higher temperatures and winter will bring down average temperature answers.

Investment – When we have seen the price of shares at some number then our mind gets attached to it. When the price moves lower from that previously seen price then we consider it as cheaper and buy it. Works with the stock market, when we intend to buy any equity, we got anchors with the previous prices and make decisions according to it rather than going for the absolute value of the stock which we want to own. We do not focus on the fundamental value. When we have seen stock price at Rs.100 and it has fallen to Rs.50, we tend to run for buying that stock as it has become 50% cheaper from what it tends to be. But we do not think that it may be possible that there may be any reason behind this fall in price. We easily get anchored with the numbers and then we start thinking around that numbers.

We just think of price, do not think of value or fundamentals of business. So that we should not focus on prices rather just have to focus on business, fundamentals, and value. We should keep adjusting the fundamental value of the company and does not keep anchoring with the stock price. If we cannot able to do it properly then we have to face a loss in the future also.

When the market is in a bull phase, people are ready to buy companies that are traded at higher valuation multiples. But opposite to it, when the bear phase comes, people want to pay lower valuation multiples.