I have seen in many big channels. An impostor with same avatar as a channel owner would post in comments to take advantage of innocent viewers.
This has now come to our channel as well.
Though I am feeling proud that our channel has grown to that level, I am also worried that an innocent might fall for that trap.
Please, do not fall prey for those impostors.
There are couple of ways we can identify a fake impostor. First clue - their comment will not have just plain text, but also many special characters.
Second clue is “phone number”. If you see any one of these, you should be aware that the person is a fake impostor.
Do not have any communication with them. Most importantly, do not send any money to them.
I am also blocking fake accounts like that as much as possible. Anyways, let's get into Today’s episode now.
Today’s topic is “Behavioral Finance”. As we saw in last episode, we are our first enemy.
Regardless of how much we try to make a rationale decision, our mind works in a different way.
If we know where our mind could mislead us in making a decision, we could at least try to avoid that.
We will take a closer look at that in this episode. Hi. My name is Vijay Mohan. You are watching “Investment Insights”.
Let’s say that we have bought a stock for Rs.500. If it has fallen down by 40% to Rs.300, how many of us would sell it?
We won’t sell it that easily? Why? There are some behavioral reasons for that. Let’s check that out one by one.
First is Anchoring Effect. Our mind gets psychologically locked to our original purchase price Rs.500.
Our neighbor would have bought the same stock for Rs.400. His mind would have been locked to Rs.400.
But does market care about which price have we or our neighbor bought the stock for? Why would it?
As far as market is concerned, it sets the price depending on the demand and quality of the stock at that time.
It does not care about the price I have paid or you have paid.
But still our mind waits for the market to recover to the price Rs.500 we paid.
Our mind waiting for a target that is relevant only to us like this is called “Anchoring Effect”.
Because we are waiting with our mind anchored to that Rs.500. We will wait to sell only if the price goes above that.
What should we do logically? We should be just looking into whether that business is profitable or not.
The price we paid for it is irrelevant. If we come to know that it is not a profitable business, we should sell and get out of it immediately.
We should not wait just because we have paid Rs.500 for it.
Continuation of this anchoring effect is “Sunk Cost”. Let’s say that we are doing a new project.
We have spent Rs.1 Crore so far. But now we come to know that there is no scope for this project from a new information.
What should we do now? Knowing that this project has no future, we should not be like “Oh, I have already spent 1 Crore on this. I cannot stop now. I should continue…”
The 1 crore that we have already spent is called “Sunk Cost”. It is done for. The money is gone.
We blew it away without realizing that we are working on a project that has no scope.
But we should stop working on it when we come to know the truth. We should not consider money that is already spent on a current decision making.
It is same in stock market investment as well.
In our example, just because we have already spent Rs.500, we should not continue to invest more on it - especially after knowing that it is not a profitable business.
The right decision is to sell and get out of a loss making business. That decision should not have any dependency on Rs.300 loss we will incur.
It is easy to say that. But it has some practical psychological difficulties.
For our human mind, the sadness from a loss is many times bigger than happiness from a profit.
That is, compared to the happiness from the price going from 500 to 600, the sadness from the price going to 400 from 500 is lot bigger.
To decrease that sadness, we try to see that as a paper loss.
“It will be an actual loss only if I sell. Let’s keep it as paper loss without selling. It will come back up one day” is the blind reason that we give ourselves.
This is called as “Loss Aversion” bias. There is another interesting thing here.
If the price goes up from 500 to 600, the chances of us selling it and realizing the profit is higher.
But if the price has gone down from 500 to 400, we will not realize that Rs.100 loss that easily. That is called as “Disposition effect”.
Rs.100 profit. Rs.100 loss. The absolute value is same in both the situations. But our mind does not see it that way.
It keeps them in different compartments and gives different importance to each.
This is the reason that many sell their winners soon and hold on to their losers for long.
Why is our mind keeping the same Rs.100 in different compartments? There is another example for that.
Let’s say that we are going to a movie theater to watch a movie. We have already reserved the ticket by paying Rs.500.
Only after coming to the theater we are realizing that we do not have the ticket with us. What would we do now?
What is the chance of us buying another ticket by paying another Rs.500?
Now let’s see the same scenario in a different way. We did not reserve the ticket at all.
We are in theater now. When we open our wallet to buy the ticket, we are realizing that it has only Rs.500 instead of Rs.1,000 we put in there.
Someone has stolen Rs.500. Now, what is the chance of us to buy the ticket now?
In both the situation, the loss is Rs.500. But the chances of us buying the ticket and watching the movie is higher in second scenario than the first one.
This is “Mental Accounting”. Our mind keeps the money in different compartments and does the profit/loss calculation based on that.
There is no logic or rationale behind it.
In the first scenario, our mind thinks like, “I have already spent the money for the ticket. Should I spend again for the same reason?”.
But in second scenario, we convince ourself that the loss of money has nothing to do with buying the ticket for the movie. So we will buy the ticket and watch the movie.
This same “Mental Accounting” makes us to see the bonus from our work place different from our regular salary.
Both salary and bonus are same money. Both belong to us. We got paid as compensation for our work.
But we treat the bonus as if we got it for free and will not hesitate to splurge.
Next “Framing Bias”. When we make a decision, we do not make it based on facts, but rather on the way it was presented to us.
That is “Framing Bias”. Let’s say that there is a financial product.
The ad says, “If you invest in this, and if the profit from this is Rs.500, then we will take 20% Rs.100 as fees and will give Rs.400 to you”.
If we see this ad, what do we think? We will say, “20% fees? That is too much.”
But if they say, “If you invest in this, we will give up to Rs.400 as profit”, how do we think now?
We will focus on the profit Rs.400 that we are going to get. We will not care about the fees that they are going to take way.
Both the products are same. But the chances of us getting convinced with that product changes depending on the way it is presented to us.
Where can we see this framing very obvious? We can see this in insurance products like ULIPs.
We will know that it is neither a good insurance product, Nor a good investment product when we do the math properly.
But the way they present to us, it will be very convincing to us.
So if your bank manager is recommending a product to you or if your relative is recommending an insurance, do not buy them blindly.
Make sure that they are giving the complete details to you and then make the decision.
Next “Survivorship Bias”. Who is writing the history? Winners write the history.
So we know only the story of winners. No one knows about the story of the losers.
If we come to know about a very successful options trader, what do we think? We will think that we can easily be successful like them if we trade options as well.
But have we thought about, how many would have lost everything by trading in options? Doubt it. That is “Survivorship Bias”.
We see only the few who have won. We do not get to see many who have tried the same and lost.
There is another famous example for this “Survivorship Bias”.
During second world war, US army was researching into how to make their planes stronger by fixing the weakness in them.
When they looked into the planes that came back from war, they noticed lot of bullet holes on their winds and tail.
So what should we do to make these planes stronger? We should make those affected wings and tail stronger - right?
A young statistician - Abraham Wald thought in a different way. “We are looking at planes that have got back safely.
“We should be actually protecting the planes that did not come back as they got shot by the enemies.”
Why didn’t they come back? Because they got hit by the bullets, not in its wings or in tail, but in other parts.
“So we should be actually making the other parts stronger” was his explanation.
Just like he recommended, when they made the other parts better shielded, more planes got back from the war.
Charlie Munger has said, “Invert. Always Invert.”
He says, “I do not think about where I can survive. I think about where I could possibly die and avoid going there.”
That is, for every decision, we should learn to think opposite. When we learn to see both the sides, we will make better decisions in our life. Including in investments.
Finally, Warren Buffet’s famous quote.
“Be fearful, when others are greedy. Be greedy when others are fearful”.
That is, when everyone is greedy in the market, we should be fearful. But when everyone is scared and running to get out, that is when we should get greed.
We should remember that all the time. Especially during market downturn.
There are many other cognitive biases as well. I will add some good reference links in the description below.
Check it out if you are interested. When we are aware of these biases, we will one step ahead of others in the market. Good Luck!
We will soon meet again in another episode. Thank You.