THE DUBIOUS EFFICACY OF DOCTORS, CONSULTANTS AND PSYCHOTHERAPISTS -Regression to Mean

Posted on by under Behavioral Finance

Everything in a world moves toward an extreme direction from average and come back to average. This is known as a regression to mean. Sometimes we get more happy or sad and as time passes, we start coming back to our normal feelings. We tend to be nice to other people when they please us and nasty when they do not, we are statistically punished for being nice and rewarded for being nasty.

Poor performance was typically followed by improvement and good performance by deterioration, without any help from either praise or punishment. Our performance has an average point, sometimes we perform very better than average and sometimes perform below average and sometimes reach back to mean performance. So that when performance is above or below average, then it has a higher probability to meet the average which is known as a regression to the mean.

Investment – The price of the companies sometimes go either extreme to fundamental points but as time passes stock prices start moving towards fundamental performance and at some point fundamental performance and stock prices marched. The stock price cannot be sustained at either extreme. We have seen various cyclical events, business cycle and many more are responsible for the regression to the mean. We have experienced that market always walk away from averages for a period but it comes near to mean by its self-correcting nature. So that when anything moves at the extreme side of the mean then we must have to be ready for self-correction of it. Value investing mainly focus on reversion to mean theory. It believes that if the stock price is well below its fundamental value then now or later it will catch up with its fundamental value.

We have seen that the best performance in equities has come after the worst performance and vice-versa. So that we should not focus on a smaller period of outcome to make any conclusion. Rather should focus on a decently long period to understand mean reversion. But when fundamental performance is improving then we should compare market price with improving fundamental performance rather should wait to fall in price as it has risen in past. Also, we need to study thoroughly about fundamental of any business, its prospects, challenges faced by the business. Rather believing that if the business has performed well in past then it will repeat it in future. It may or may not repeat the same performance but that we have to conclude from a detail study of business.

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

NEVER PAY YOUR LAWYER BY THE HOUR – Incentive Super-Response Tendency

Posted on by under Behavioral Finance

People respond to incentives by doing what is in their best interests. What is noteworthy is, first, how quickly and radically people’s behaviour changes when incentives come into play or are altered and, second, the fact that people respond to the incentives themselves and not the grander intentions behind them.

We all seek self-interest; our efforts get changed with incentives. We act for getting back something. Proper incentives can improve performance but improper incentives can spoil the performance. We assess the risks and the associated rewards and respond in a way that seems to best serve us.

Business – For example, incentives for selling every single loan will spoil credit quality but if we keep negatives incentives on every NPAs then performance will get improves with safety in nature. The sub-prime housing crisis in the US is one example of incentive bias. 

Investment – There will be incentives on different products to marketing personnel and due to that incentives, they sell products where they get higher incentives. The same happens with the stock market products. We have experienced Franklin mutual fund debt scheme example where distributors have decent commission available. And distributors have aggressively sold scheme to the investors.

Many a time, management focus on their performance incentive over an above of long-term benefits of shareholders. That is the reason to provide ESOP to top management (aggressive ESOP has its disadvantage, which we will discuss later on).

When we study pieces of advice given to us by others than 90% of cases having incentive effects hidden into it. We need to study the given pieces of advice thoroughly before accepting it. If we work on anyone’s advised without putting our efforts then that will become our fault.

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

YOU CONTROL LESS THAN YOU THINK -Illusion of Control

Posted on by under Behavioral Finance

Many of us have different superstition about our acts. We believe that if we perform a few tasks in some pattern or after performing some other task then we will gain. The illusion of control is the tendency to believe that we can influence something over which we have absolutely no sway.

Government, central banks and the world’s largest authorities believe that they have many tools by which they can control things the way they should be. And they use one tool after another. Few things might get control for that particular period but cannot be guaranteed for the future. We should rather focus on everything and try to control it; we should learn what we can influence and should perform.

Investment – Many participants in the stock market think that they can have tools by which they can catch every market movements and reap profits from them. Yup, they maybe can do it for some time, for some short period but is it possible for them to do it again and again? We cannot control the majority of things which we have to understand and perform the task according to it. The majority of the time, we live in an illusion of control but should understand that we cannot control the majority of things in the world. Many market participants focus on capturing each movement of the market and try to catch all gaining stocks. But should have understood that, it is not possible to do. So that rather than running behind each strategy to operate in the market, we should define a strategy that can be suitable to us and have to do it tested for longer periods. We only can control our own behaviour so we should focus on that part.

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

DON’T TAKE NEWS ANCHORS SERIOUSLY – Chauffeur Knowledge

Posted on by under Behavioral Finance

There are two types of knowledge. First, we have real knowledge. We see it in people who have committed a large amount of time and effort to understand a topic.

The second type is chauffeur knowledge – knowledge from people who have learned to put on a show. These people just make show that they know everything but they just speak what they have heard from the source. They speak as per the predefined script ready for them.

Any fool can know. The point is to understand. – A. Einstein




Source – Vivify

Investment – It is difficult to judge who is an expert and who has just a bird view of knowledge.

In 1998 Wesco meeting, Charlie Munger Quoted –

I try to get rid of people who always confidently answer questions about which they don’t have any real knowledge. To me, they are like the bee dancing its incoherent dance. They are just screwing up the hive.

Mr Warren Buffett suggests us to decide what we know and stay with it, what he calls a circle of competence. Mr Munger suggests that the size of the circle is not important but important is, we stay within its limit well. If we do not know anything, we should simply say we don’t know rather act as an expert. I also faced such problems during the initial days of my career. I considered people with Chauffeur knowledge as an expert until I do not meet real experts.

In the stock market, we meet many people who act as an expert but the majority of them not. We have to carefully check their knowledge before trust on them. We have to understand their investment philosophy and process before making a judgement of them. True experts recognize the limits of what they know and what they do not know. If they find themselves outside their circle of competence, they keep quiet or simply say, ‘I don’t know.’ We also have to perform the same for becoming an expert in our field.

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