03 – System 2 efforts

Posted on November 8, 2020 by Jimit Zaveri under Behavioral Finance

Attention and Effort

System 2 is effortful and one of its main characteristics is laziness, a reluctance to invest more effort than is strictly necessary. System 2 efforts and self-control help us to overcome intuitions and impulses of System 1.

Mental Effort

For testing of our system 2, we have a game which helps us to know the efforts of our system 2. We prepare a few cards and on which we write the four-digit number. Then we pick up cards randomly and add-1 to each number written on a card. For example, if the number on the card is 1125 then answer will be 2236. We find it easier so now, we can try it with more difficulties and use add-3. That means if the number on the card is 1125 then answer will be 4458.

Our pupils are sensitive indicators of mental efforts so whenever we put any mental efforts to think our pupil size gets change. When we start working on any problems our pupils get larger in size and as we get solutions or give up then pupil size start contracting.

Switching from one task to another is also requires mental efforts and which uses system 2.

Modern tests of working memory require the individual to switch repeatedly between two demanding tasks, retaining the results of one operation while performing the other. People who do well on these tests tend to do well on tests of general intelligence. We generally tend to break down works in a smaller part to perform it well. We generally use the law of least efforts.

The Busy and Depleted System 2

When we are putting mental efforts means system 2 is busy in thinking so that system 1 take charge of our immediate decisions. If someone asked us to select food during that time, system 1 mostly go with temptation food, go with sweet foods. There can be selfish decisions. Higher the demand for system 2, higher the self-control which is depleting and unpleasant.

Sometimes when we have put efforts in one task, we tend to avoid putting efforts on others. And sometimes, we accept to put efforts on others. When we have a strong incentive to do so.

When you are actively involved in difficult cognitive reasoning or engaged in a task that requires self-control, your blood glucose level drops. So, giving glucose to the brain helps to put more mental efforts. That’s why sweet foods, temptation foods and activities which we love to perform getting demanded when we have put huge mental efforts and we get tired mentally. These things help to give energy and rest to system 2 so that system 2 is getting ready for another mental effort.

The Lazy System 2

Many people are overconfident in nature and also that have an overconfident on their intuition. So that they avoid taking decision by taking the help of system 2.

When people believe a conclusion is true, they are also very likely to believe arguments that appear to support it, even when these arguments are unsound.

Similarly, while making an investment, we majority times use system 1 and avoid uses of system 2. So, we reach the conclusion and accept the arguments which support our investment though it’s correct or not. Though we have invested wrongly, we do not listen to it and just seek for supporting arguments.

Those who do not fall under such a trap and uses system 2 whenever required. They are more rational. So that we should not be biased with our investment and keep collecting information which is against our original hypothesis.

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

02 – Conflict, Illusions and Useful Fictions

Posted on October 25, 2020 by Jimit Zaveri under Behavioral Finance

Conflict

System 2 is an in-charge of self-control. It helps us while we are losing our control, focus, emotions. While we are reading a book and found something boring in it and start losing focus towards continuing with a book then system 2 bring back our focus to the point. When System 1 indicates that it’s boring then system 2 brings back our focus.

When we have invested in business and stock price of that company not moving then we start getting boring with time. But system 2 help us to guide that business has improved in performance and there are not any fundamental issues. Focus on our process and sticking with it is the work of system 2.

Illusions

At the first instance, we have reached the conclusion that the second line is larger in size compared to the first one. But when we measured both the horizontal lines, we found that both are identical in size.

Here, system 1 has accepted view of the second line is larger than the first one and when we have measured, system 2 took control. But system 1 prevents us from believing that both lines are equal, it’s illusions. Though we have measured and know the size of both the line, we cannot stop system 1 from performing. When we can work on accepting that both lines are identical, we will not again get fooled by multilayer illusions.

There are illusions of thoughts along with visual illusions and that called as a cognitive illusion.

Many times, a person does not accept the reality and try to stay in the illusion, means their system 1 only works and they do not accept what system 2 indicates. System 1 has intuitive errors and biases which system 2 is not aware of. Errors can be prevented only by the enhanced monitoring and effortful activity of System 2. But it seems impractical to continue monitoring of thoughts and go slow on routine works. It will be inefficient if we replaced system 1 by system 2. We have to identify where mistakes are likely to happen and then have to give control to system 2. It’s difficult to identify your own mistakes compared to others.

Example – when we analyse the company and see a few characteristics which we like about the company then we stop focusing on others which can have a negative impact on the future prospects of the company. Dividend-paying companies are good which is stored in system 1 so that when we look at the company which is continuously paying out a dividend. We do not focus on other aspects and make an investment. But when system 2 take control, it will analyses whether the company has the ability to keep dividend continue in future, does company paying dividend from free cash flow or from raising external funding.

We should use system 1 where rules are predefined such as we are not eligible to get a dividend if we purchase shares on or after ex-date. But analyzing the longevity of dividend, we need to use system 2.

Useful Fictions

System 2 required a mental calculation so that we should not use it with other tasks.

When we are driving on a similar road frequently since long, our system 1 works automatically. It will suggest that when to take turns, at which area have slowdown speed, etc. It will not be going to ask for system 2 helps. We can drive on a known road while making a conversation. But the same does not happen when we drive on an unknown road. Our system 2 take control and if we make conversation while driving on an unknown road, we may meet accidents or miss with target place.

Anything that occupies our working memory reduces our ability to think. So that we have to be careful to perform multitasking. When people get involved in both trading and investment than both require the involvement of system 2 so that it will become difficult for the human brain to make a wise decision to cover all aspects. And that can result in missing out of something at both the area.

01 – The character of the story

Posted on October 11, 2020 by Jimit Zaveri under 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“.

When we look at the face of woman, we immediately responded that she is angry and we also assume that what she can do next. This thinking is known as fast or intuitive thinking.

But what happens when any mathematical problem comes?

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Now, we come to know that we have to do a calculation to reach out with a true answer as well as to reject a false answer.

Here, we realize that this problem is of multiplication and then we start implementing it. This step by step procedure slows down our response. Deliberate, effortful and orderly procedures are the prototype of slow thinking. When we face such problems then not only our mind works but heartbeat changes, blood pressure rate changes, etc. So that body also experiences it. When we are into known situation or problem, we can easily handle it and our mind, body, heartbeat does not change so rapidly. But when we are into the unknown situation which requires huge mental efforts then our mind starts processing it slowly, heartbeat, the body will feel that unknown situation.

Why does such a difference happen?

System 1 works on patterns and system 2 works on thoughts construction in an orderly manner. So that when we have seen the face of woman, our mind has searched for different patterns which we have experienced in the past and our brain throw matched pattern quickly which comes as a conclusion that woman is angry. While the mathematical problem is not storing under our mind and that requires to perform a calculation which slows down brain work.

We have been kept on learning about various things over a period, those learning got stored under memories and it comes out automatically when a similar recognizable pattern occurs. Such memories come as a conclusion without any intention and efforts.

System 2 also have abilities such as system 1. For that, we have to set our mind. For example, when we search our name in the merit list, we search with our initial. Those activities demand our efforts, we generally do not perform it with other activities. And which activities are automatically coming, naturally happens, we can perform other activities with it.

When some situations demand our attention, we generally do not see or hear anything else.

For example – We need to count ball passes by one to another person in below video.

Video

Majority of us have missed something unusual which has occurred in the video, come out of a gorilla. Majority of us have not noticed because we have given a task of counting passes. This counting requires an effort and that makes us blind to focus on coming out of a gorilla. This event indicates that we can be blind to the obvious, and we are also blind to our blindness. We are not aware of our inability to observe things happening surrounding while we perform some task which requires mental efforts.

When we have put efforts on price moments of particular stock then we going to be blind with what happening towards the business side. Management of the company who is engaged towards the stock price then he will lose focus towards the business and that will fail in business.

System 1 runs automatically with giving suggestions to system 2 and many times system 2 accept the suggestion of system 1. But when system 1 faces difficulties, it calls system 2 for support. System 2 continuously monitor our behaviour and work on control it. It comes in attention when it finds error about to happen. Arrangements of system 1 and 2 works on minimizing efforts and optimization of performance.

The Intelligent Investor – 8 – The Investor and Market Fluctuations

Posted on October 5, 2019 by Jimit Zaveri under Bibliophile: The Intelligent Investor

When we have invested in the bonds then that will get little fluctuation to the market price. But when we have invested in the common stocks then it will have a wider fluctuation to the market price. So that we need to be ready financially and psychologically for upcoming fluctuation into our common stock investment. It is easy to advise for not doing a speculate but hard to follow it. Fluctuation and behavior of the market attract us to make a speculative decision. So, if we want to make a speculative decision then keep aside some amount of money as considering that we are going to lose it through speculation.

We need to take a benefit from the swing of the market pendulum rather than getting trapped into it. And we can take a benefit by way of timing to the market or through pricing.

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We cannot predict the direction of the market consistently and if we start predicting a direction then we end up as a speculator, not as an investor. People want to buy during the bear market where everyone else is selling and sell during the bull market where everyone else is buying. But people are tending to do the reverse, the majority of the people buy at high / during a bull market and sell at low / during a bear market.

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Similar has happened during the year 2017, people have seen a bull market from the year 2014 to 2017 and they started believing that this will never be going to end and stock prices keep on going higher and higher.

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1^st, 2^nd and 3^rd point has been explained to the previous articles of the same series.

One of the optical and data networking products company

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IPO of the company came at Rs.257 so that MCap was ~Rs.2367cr which was at the EV/EBITDA of 14.09x in FY17 and stock price rose to ~Rs.437 in FY18 which was at EV/EBITDA of ~26.33x. The company has incurred losses in a few years and came to profit since FY2016.

One of the publication company

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The IPO of the company came at P/E of 33x and EV/EBITDA of 16.59x.

Day-to-day or month-on-month fluctuation to the market does not make investors richer or poorer. But what will happen for a longer period that will impact the wealth of investors. We need to keep distance ourselves from the crowd rather than go with the crowd. Also, we need to focus on emotional stability over an investment journey which helps us a lot. The normal investor gets trapped with greed as the market starts advances, but at the same time, intelligent investors booked a position of overpriced issues and parked those funds to bond, he will re-balance his portfolio.

Owning a common stock means we are a part-owner of the business, but due to the advancement of the stock market operation, investor’s mind gets diverted and they are getting more engaged towards the stock prices. They forget that stock price fluctuation should not be focused but they have to focus on the value of the businesses, quality of the businesses and progress of the businesses. Stock prices bring distance between business and us. If a person is making an investment for a longer period, but getting fluctuated as stock prices get fluctuate then he does not know for the emotionally stable and matured investors. Matured and intelligent investors do not focus on the price quotation every second but they focus on the underlying business. As businesses show successes it becomes popular among the people and it will command more premium, its mood swings with the market, etc.

We need to focus on earning the power of the business with the asset value of the business. But we should avoid paying higher to the assets as well as to the earning, otherwise, we need to be stay affected through the market fluctuation.

One of the telecom company

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(Source – Thoughts on Thoughts blog)

The company looks very cheap based on the financial metrics and assets base, but if someone who does not have paid attention to the business of the company and earning the power of the business then—

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One of the gelatin company

The company has some uncertainty and raw material problems but having a stable business. The company was traded at ~Rs.66 cr of MCap with having investment + cash on the balance sheet was worth of ~Rs.70+ cr so that entire business was available at free due to uncertainty. The company has delivered a decent return with also deliver Rs.10/per share as a dividend.

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Few critics of value-based investing tell that such an approach does not work with the listed companies due to the ample amount of liquidity available. Such liquidity and stock market platform provide a daily opportunity to the participants to make changes to their holdings.

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Many a time, Mr. Market ready to pay overpriced for the business and sometimes, He is ignoring too few of the businesses. We need to stay away to getting trapped from the Mr. Market mood swings. Mr. Market also behaves like a human being because prices of it and the behavior of it direct through human involvement as a market participant. We need to control our emotions based on our experience and belief over a while. We should stop overpaying attention to the market.

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If we are doing a business then daily price fluctuations will not be going to disturb us and we do not make a change to our holdings. Price fluctuations only provide an opportunity to buy a business at a favorable price and sell when Mr. Market shows a higher price of the business.

The main distinction between speculators and investors is their attitude towards the market. A speculator is willing to make profits by way of market fluctuations whereas investors are willing to hold security at a suitable price and market fluctuations do not important for them. Market prices are just for our conviction so that taking benefits of it or to ignore it depends on us.

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Stocks or a bond, the Market price will remain to fluctuate over a longer-term period. Good company with good management gets recognition into the good market price and bad management will get bad market price recognition.

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Mr. Graham has explained the liquidity concepts which is suitable for the current scenario. The fund manager purchases few stocks for the portfolio, then the market starts moving upwards which attracts the investors to put more money. Now, due to the additional fund inflow, the fund manager has to buy a similar stock to the additional fund which brings stock prices to the dangerous level. Now, as the market falls, investors ask for the withdrawal of the fund and fund manager has sold out stocks to make the payment which leads to further fall to the stock prices. So here, they buy at high and sell at a low price. Our brain makes a pattern that similar has happened during the last time so it might be going to happens now also. And many times, our brain creates a pattern when there is not the availability of any pattern.

What we should need to do for the better than average return –

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Our behavior is most important to get an above-average return. By controlling ourselves, we can stop ourselves from becoming our enemy. When we have made any prediction and that proven right then we become addicted to own predictions.

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