Tag Archives: sub-prime crisis

WHY YOU’LL SOON BE PLAYING MEGATRILLIONS Neglect of Probability and Prospect Theory

Posted on by under Behavioral Finance

Problem 1: Which do you choose?

Get Rs.900 for sure OR 90% chance to get Rs.1,000

Problem 2: Which do you choose?

Lose Rs.900 for sure OR 90% chance to lose Rs.1,000

What we will choose in problem 1 and problem 2?

When this is asked, the majority of us choose sure Rs.900 in problem 1 and second option while it comes to problem 2. We performed risk-averse behavior during problem 1 but risk-taker during problem 2. Here, also we neglect probabilities, we get fearless when we have the option to zero loss. And above zero, we will have fear.

The (negative) value of losing Rs.900 is much more than 90% of the (negative) value of losing Rs.1,000. The sure loss is very aversive, and this drives you to take the risk.

But when we do mathematics then only, we can understand that both options in both the problems are similar.

Getting Rs.900 for sure or Rs.900 which is 90% of Rs.1000. And a loss of Rs.900 or Rs.900 which is 90% of Rs.1000.

Our psychological factors affect us for making such decisions. We differently behave to profit and loss. Here, counter to the utility theory is, – our risk behavior does not get changed with our net worth. we also know that our attitudes to gains and losses are not derived from our evaluation of wealth.

Investment – When we have uncertainty, people fear to invest. But when things start becoming certain everyone rushes for investment. This is a reason why people come to invest when the market is near an all-time high because they get sure that they will not face loss now.

If we focus on probabilities then we can make a wise and rational decision that helps us to progress further. We should assign probabilities to the occurrence of different events so that we have statistical support to make a wise decision rather than just make it with support from emotions.

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

THE CALAMITY OF CONFORMITY Groupthink

Posted on by under Behavioral Finance

When we work in a group than as social animals, our thinking and decision get influence by the thinking of the group. Slowly we start losing our own identity of thought process. People who are opposed to the decisions or overriding opinions of the group as a whole frequently remain quiet, preferring to keep the peace rather than disrupt the uniformity of the crowd. Those who question the group are often seen as disloyal or traitorous.

If you ever find yourself in a tight, unanimous group, you must speak your mind, even if your team does not like it. Question tacit assumptions, even if you risk expulsion from the warm nest. And, if you lead a group, appoint someone as devil’s advocate. He will not be the most popular member of the team, but he might be the most important.

Business – When a team member / BOD expresses an opposing opinion or questions the rationale behind a decision, the rest of the team members work together to pressure or penalize that person. This will lead to a lack of innovation or lack of avoidance of risk. Businesses will follow what the industry is doing. Businesses should appoint a person who acts as an opponent of any view which can help to generate different perspectives and better decision making. The company also has to work towards protecting that person. Because uniform group sees different opinion and a person as an inferior, also treat him differently. They need to allows team members to contribute individually, with no knowledge of a group view, and with little or no penalty for disagreement. This can be very difficult in today’s era of technology. But one can keep a penalty for similar views which can invite different opinions.

Investment – When everyone comes to us for investing in a particular company, we have to work as a devil advocate to counter that investment idea. Because that will help us to see positive as well as the negative side of the company. If we get to agree with what the group has decided then it may be possible that we ended up with huge losses. And only seeing one positive or negative side of an investment can be harmful to us in the longer term. We need to see both the side properly with all supported data without getting biased on one side. If we like any investment then have to prepare a document which says why we should avoid investment. And if we dislike any investment then have to prepare a document which says why we should invest in that, what lead to miss out of the opportunity.

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

THE INEVITABILITY OF UNLIKELY EVENTS Coincidence

Posted on by under Behavioral Finance

A few times, we think about our friends or relatives and suddenly they come or they call us. Is it telepathy or coincidence?

But many times it happens that when you think of him and he doesn’t call; when you don’t think of him and he calls; when he doesn’t think of you and you call?. . .? There is an almost infinite number of occasions when you don’t think of him and he doesn’t call. But, since people spend about 90% of their time thinking about others, it is not unlikely that, eventually, two people will think of each other and one of them will pick up the phone.

Investment – Such kinds of events are rare but can happen. It can happen that when we punching order to buy some stock and management’s interview comes and announced for subdued performance in the coming quarter. So this can be a coincidence, not that God giving us a sign to do not buy a particular company as of now. So that we have to clearly focus on the investment process prepared by us and must follow it rigorously.

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 CLING TO THINGS Endowment Effect

Posted on by under Behavioral Finance

When we own something, the value of that particular things has psychologically increased for us. Loss aversion stops us from giving up what we own. We are slowly getting emotionally attached to particular products and automatically the value of that product increases for us.

We consider things to be more valuable the moment we own them. In other words, if we are selling something, we charge more for it than what we would be willing to spend for the same thing. We get attached to things we own and we keep on collecting different things. We can safely say that we are better at collecting things than at casting them off. Not only does this explain why we fill our homes with junk, but also why lovers of stamps, watches and pieces of art part with them so seldomly.

We should understand that everything which we own is given by the universe to us for temporary time so should not get attached to it. These things can get separated from us in the blink of eyes.

Business – We can see that owner of the business who is facing losses then also not ready to sell off the business. Also, they seek higher prices to divest business though business incurring losses. The founder of the business is emotionally attached to the business and want to focus on making it profitable. 

Investment – When we own any stocks in our portfolio then we value it more and think that all others own fewer valuable stocks in their portfolio. We tend to sell our ownership for more than what it’s demanded. We feel portfolio companies have higher value and should trade higher than our acquired price. We also keep on purchasing stocks and then when we have owned it, we want to sell it for higher.

This attachment with our portfolio makes us blind to make a rational decision. That’s the reason our portfolio gets flooded with junks and we sell quality because the quality we can sell at a higher value than what we own.

Rather than keep focusing on the purchase price, we should focus on what is a current intrinsic value and fundamental of the company. When we start to avoid looking at the purchase price, the time we start reducing a few mistakes. First, we should write down the exit strategy during the entry time itself and follow it thoroughly. When our exit strategy has been triggered, we should not look at the trading price and dump a particular investment. A clear strategy helps us from the endowment effect.

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