We judge something to be beautiful, expensive or large if we have something ugly, cheap or small in front of us. We have difficulty with absolute judgements. So that we always decide on a relative basis.
When a person goes for a marriage meeting and wants to get selected in meeting then he should go with a below normal-looking friend or need to go alone rather go with a handsome looking friend. When a person looks nice comparatively then he has a higher chance of getting selected.
We cannot see small changes over a period so that Contrast effect make us blind through small changes.
Business – A product that has been reduced price from $100 to $70 seems better value than a product that has always cost $70. The starting price should play no role. Majority of the businesses uses this technique to attract more customers and increases their business.
Another technique used by businesses to sell 2 different products where one has some lower feature than the later product but the later product has slightly higher in price than a first product which attracts customers to buy the later product.
Investment – Initial days of my career, I have to communicate my research works to the retail clients. So, when I recommend the idea to them, many of them ask immediately a question that what was a 52-week high and low. If a stock is near to 52 weeks high then they do not prefer to invest in it. But stock either near to 52 weeks low or substantially lower than 52 weeks high then they prefer to invest. Also, if peers stocks have posted good return then people run behind which stock do not have performed well.
We should focus on what is a potential of stock from a current point rather than where the stock stands from its 52-week high and low.
Many investors focus on relative valuation i.e.; the company is relatively cheaper than its peers then that company has more chance to give a return. This may be correct. But we need to check that does that company has potential to meet the valuation of peers. It also can be possible that the inherent problems of the company tend to deserve such a lower valuation. So that we need to study all the company in an absolute manner, prepare positive & negative points of it. then have to look at does it undervalue or overvalue rather just compare it with peers valuation for decision. Any company should get valued on its inherent merit and demerit.
Another point is that when we have diversified our portfolio to a great extend then little changes in it does not affect our portfolio and that investment slowly loses our attention. So that we need to keep portfolio size to the extent that we can give equal attention to each holding of the portfolio.
This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.