Tag Archives: Irrationality

WHY YOU SHOULD FORGET THE PAST – Sunk Cost Fallacy

Posted on by under Behavioral Finance

For Humans, mental accounts are a form of narrow framing; they keep things under control and manageable by a finite mind.

The decision to invest additional resources in a losing account, though better investments are available. This is known as the sunk-cost fallacy, a costly mistake that is observed in decisions large and small.

Many financial institutions refinance bad loans with the hope of recovering them. If the company starts doing well through an additional loan then should give an additional loan rather than book it as an NPA. This will result in a larger bad loan on the book of institutions.

We have seen that loss-making business or division keeps getting funds from the bank or financial institutions. Also, many non-performing banks keep getting recapitalization from the government. This is an example of a fall of government into the sunk cost fallacy. We have seen in “Mahabharata” that King Yudhishthira keeps on gambling with the hope of winning everything back. He considered his brothers and wife as an available resource and played for winning back his lost fortune.

Investment – When we have invested in a few stocks and those turn out to be our mistakes but we resist booked losses from it. We think that if we book losses then it will occur but we do not think that loss already occurs, just we have not accepted it. A common practice by the majority of investors follow is to book winners and hold on with losers or average losers.

The sunk cost fallacy is most dangerous when we have invested a lot of time, money, energy, or love in something. We carry out with the burden of losses and invest more in it. As we invest more, we fall further into the trap of sunk cost fallacy and cannot take the exit with losses. This is irrational. I have seen many fund managers/research analysts who cannot reject ideas after they have made good efforts, though they found something wrong about their investment idea.

Overcoming a Sunk cost fallacy, we have to understand that the acquisition price has no role to play while making an investment decision. What counts is the stock’s future performance (and the future performance of alternative investments). So that if we feel that stock is more valuable and have the potential to perform well in the future based on its fundamental (not on basis of gut feelings) from current price then only we have to hold it or invest in it. We have to delete buy price column or have to ignore it. If we have found that business has some problem and will not grow it or will not sustain then we must have to take exit because holding that will defiantly going to give us a permanent loss of capital. 

We can see in the mentioned link that the public has increased their holdings in stocks which have eroded wealth.

QUALITY INVESTING CAN BE A CONTRARIAN INVESTING….

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

IF 50 MILLION PEOPLE SAY SOMETHING FOOLISH, IT IS STILL FOOLISH – Social Proof

Posted on by under Behavioral Finance

We generally accept something as right when others are also performing it and we also start following the same. When one starts clapping at Drama show, all other starts clapping and join that fellow.

Social proof is the evil behind bubbles and stock market panic. It exists in fashion, management techniques, hobbies, religion and diets. It can paralyze whole cultures, such as when sects commit collective suicide.

It has been seen in students, they select particular stream as their career because their friends or others in their family has select it. They do not focus on what they like, whether that stream is suitable to them or not.

We have seen that when a few streams are in fashion; the majority of students chase that same stream rather focus on their skill or interest. We are a human animal so that human emotions affect our decisions.

Every time social proof does not create trouble. When we decide to go out for dinner and found 2 restaurant from which one has a crowd but other is vacant. Here, we should generally prefer a restaurant with a crowd. Herding becomes particularly useful in ambiguous situations because it simplifies the decision-making process. We should follow the crowd when the decision does not have a huge impact on our financial or in life.

Investment – When few start talking about buying a few equity investments than others also start following it and by seeing them succeed more will join their party. That will result in a bubble or burst.

We follow others without thinking about anything. When we see a few others are doing something then our mind stops giving us logical reasoning. I have met a few people before Covid-19 market panic. They were telling me that I should make the large investment as many mutual funds and PMSs have generated good returns in past. If you will not invest then you will miss out an opportunity. We should not follow what others doing rather should focus on their process. Equity investment has created wealth for people and beats inflation so everyone starts herd towards it without thinking about anything and any level. All the assets class has its merits-demerits so that we need to choose an assets class according to our temperaments rather chasing what others are doing.

Majority of the fund managers also follow social proof. If we see the various scheme of the same categories then the majority of the fund has a similar kind of portfolio. They focus on matching their benchmark return. We can see below portfolio of four different schemes of different AMCs, all those have many common stocks in their top-5 holdings.

For overcoming social proof bias, we need to create our circle of competence and investment process. We need to stick with it and let others do whatever they want to do. For example, if pure cyclical businesses do not fall under our circle of competence then we should avoid it though anyone has bought it. Also, the famous quote of Mr Buffett tells us a lot about overcoming social proof bias.

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

WHY YOU SEE SHAPES IN THE CLOUDS – Clustering Illusion

Posted on by under Behavioral Finance

Many a time, people see the face of lord or shape of the lord, shape of a heart and so on in clouds. We hear many strange voices sometimes and feel that it wants to talk to us. The human brain seeks patterns and rules. It takes one step further: if it finds no familiar patterns, it simply invents some.

In the above images, we can see different faces in clouds. But actually, there is not any real face, our imagination creates faces in it.

Investment – In the market, we are getting overloaded with lots of data and many of us try to make patterns among those data. They use such pattern for trading into stocks. But that not work forever because we have created patterns where it has no existence.

When it comes to pattern recognition, we are oversensitive. We need to regain our scepticism. If you think you have discovered a pattern, first consider it a pure chance. If it seems too good to be true, find data which is tested mathematically and statistically. Never believe in any pattern if it is not supported with enough data over a long time.

Many investors believe that the company which choose buyback as a capital allocation plan then consider that company as a good capital allocator. But do we check rather a buyback is done below its intrinsic value or above its intrinsic value? What is the intension of the company behind buyback? Does the company want to hide previously diluted equity capital through buyback? So, we need to be sceptical before considering something as it similar as we saw it.

SIMPLE IS BETTER – ISSUE -13 – BUYBACK

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

DOES HARVARD MAKE YOU SMARTER? Swimmer’s Body Illusion

Posted on by under Behavioral Finance

For becoming good swimmers, we require a good body to develop. This is not a fact but it’s a result of good swimming. Female models advertise cosmetics and thus, many female consumers believe that these products make them beautiful. But it is not the cosmetics that make these women model-like.

Whenever we confuse selection factors with results, we fall under swimmers body illusions. When it’s talking about top graduate schools then Harvard, Oxford, MIT, IIM comes on top and it is considered that pass out from those colleges will give huge success in professional life but is it true always? It may be possible that they give admission to already bright students so they do well and get a good professional life.

Investment – Mr Buffett has made wealth through moat investment so we all chase his style without knowing that it will suit us or not, without knowing that Mr Buffett also owns world’s largest insurance company which generates good float for him to invest. 

So, when we stuck under such situations, we should write down what confusing us then invert that problem. In investment, people believe that high dividend-paying companies are good. But we should understand that the company is good because it can able to generate cash which is excess after investing in all business requirements so that the company can able to pay a higher dividend. Whenever any outcome or information we received, we need to always ask a question on how that outcome has resulted. We need to understand why some companies are successful and why some not rather using any thumb rules.

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