Tag Archives: Sunk Cost Fallacy

BEWARE THE ‘SPECIAL CASE’ – Confirmation Bias

Posted on by 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 by 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

One of the telecom company of India- also low return in the last 14 years

Dialogue from Mr Salman Khan best suitable to this bias – Do me a favour, that doesn’t do me any favours. (Idea taken from SafalNiveshak)

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.

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 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“.