LEAVE YOUR SUPERMODEL FRIENDS AT HOME – Contrast Effect

Posted on January 24, 2021 by Jimit Zaveri under Behavioral Finance

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“.

DON’T BOW TO AUTHORITY – Authority Bias

Posted on January 17, 2021 by Jimit Zaveri under Behavioral Finance

Authority bias comes when we put an extreme trust on authority, expert of a particular field. We just follow what they say and do not doubt on their opinions.

Whenever you are about to make a decision, think about which authority figures might be exerting an influence on your reasoning. And when you encounter one in the flesh, do your best to challenge him or her.

Business – Corporate has authority bias as founder, CEOs, directors pass an order and everyone follows it. If someone has viewed with proper data, facts and logic then also cannot challenge their order.

Successful business houses have the practice to invite better ideas from different employees group or department so that they get better insights for improving efficiency and operation.

Investment – Comeback to the stock market, we follow many of the celebrated investors, fund managers and we consider them as an authority. We do not argue on their opinion, investments thesis. We also tend to follow what they are doing. This behaviour is very rapidly affecting the majority of the participants. If Mr XYZ has bought ABC stock then the majority of us do not think anything and just run to buy ABC.

We should work on the preparation of process & checklist from listening, reading each guru, books etc. The process should be on what suits our temperament. It may be possible that few aspects may not be accepted by our process what authority says then we should not to do. Evolve from this bias can help us with becoming an independent investor rather than being depending on the authority.

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

BEWARE THE ‘SPECIAL CASE’ – Confirmation Bias

Posted on January 10, 2021 by Jimit Zaveri under Behavioral Finance

The confirmation bias is the mother of all misconceptions. It is the tendency to interpret new information so that it becomes compatible with our existing theories, beliefs and convictions.

We have some initial thoughts, opinion on anything and we try to collect information, evidence which supports our initial thoughts. And kick out evidence which does not support our initial thoughts.

We inevitably land in communities of like-minded people, further reinforcing our convictions – and the confirmation bias. We generally like people who have similar interest as of us. So, this association will again influence our decision making. We should have people in our life who can show us the other side of the coin rather keep supporting our views. Our mind does not accept opposite views so that we have to make it habituate our mind to accept the opposite idea.

Business – When any management makes any kind of capital allocation decision then they will start collecting information which is supporting their decision. But we should check that management get succeed who have a focus on both optimistic as well as a pessimistic result of their decision.

We have mainly seen such behaviour among the management of cyclical industries. When the business cycle starts improving, then management focuses on increasing higher capacity, disturbing balance sheet, etc. rather improve efficiency and strengthening balance sheet to be ready for an upcoming burst in the cycle. Good management focuses on increasing capacity when everyone avoids so that they can take benefits when the cycle turns to be profitable.

Investment – When we have invested in a particular company, we try to find out evidence which supports our investment, which tells us that we will gain from this investment. When we are fully invested with all our money, we work on identifying evidence which tells us that market will do well and we will earn good returns. Reversely, when we have a huge fund to get invested, we work on collecting evidence that tells us market will go down and we will get good investment opportunities. Rather falling in confirmation bias, we should try to collect positive as well as negative evidence with a neutral mind decide to continue with original thoughts or to modify or change it.

Many a time, I have seen that people get emotionally attached to their investment so that they do not want to hear anything against their investment. We have to understand that our decision does not prove to be correct every time.

We should write down our initial belief and work on collecting disconfirming evidence to our initial belief. When we have confirmed as well as disconfirming evidence then we can make wise & rational decision without getting biased. When we have invested in a particular company then we should prepare a sell report on the same company. And if we have not invested then should work on collecting evidence which tells us why we should invest at the current point of time.

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 ACCEPT FREE DRINKS – Reciprocity

Posted on January 3, 2021 by Jimit Zaveri under Behavioral Finance

Many NGOs, philanthropic institutions give us a gift and welcome us. After that when they feel that we have fallen under the softcore for them due to gift, they ask for the donation. Reciprocity is a very useful survival strategy, a form of risk management.

It is at the core of cooperation between people who are not related to each other and a necessary ingredient for economic growth and wealth creation. Reciprocity rule said that we try to repay what we get from someone. At last, we all are social animals. And when we give something to someone, we expect something in return. This is how our social life has been designed. This bias is so strong that by this, we can influence thinking and decision making of other people.

Business – This method is best used by marketing fellow who comes to us with some exciting advice free of cost and in return, we will buy what they are selling. When sales personnel put lots of efforts on us then we try to buy something from them. When any company keeps taking care of their customers such as sending wishes on their birthday, anniversary, sending gifts, etc. then those happy customers will buy services from that company on a repeated basis.

Investment – when we like the products or services of a particular company, we try to put our money into it. It is a good decision at some extend but without digging in detail putting money is an unwise decision.

Many a time, our advisors also get some benefits from the company or they like the products or services of the company so that they issue buy recommendations. Opposite of it that sometimes, any unsatisfied with the product or service of any company to any of our advisors then they might start advising to stay away from that company to put money.

We should not blindly follow anyone rather doing their homework. For overcoming this bias, we need to give us a time, we need to dig deeper on each aspect of the company. We need to write down a thesis which contains the opposite side of our decision. It’s difficult to kill your idea but its necessary.

One of the power generation and transmission business – very lower return to no return in the last 14 years