behavioral finance

Book Synopsis: The Upside of Irrationality, and How we are victims of ‘My Ideas are better than Yours’

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Another weekend another book. This time it was about irrationality and actually how it helps being irrational – The Upside of Irrationality! We are an irrational species, and that was amply demonstrated through a set of experiments that the author conducted over time.

the-upside-of-irrationalityOne of our irrationalities has to do with lack of acceptance of new ideas because “it is not made here”. Even when we know that it is rational to choose something that is better even if not made here, the irrational part of us often says – not good as it is not made here or it is not mine! There is a set of experiments that the author describes to demonstrate that – but that is besides the point. The point really is that most of us are victims of the “My ideas are better than Yours” syndrome.

That’s the reason a lot of us fall in love with the cars we buy, the houses we own and perhaps even the stocks we have – even though there might be better ones around! Well – I am not getting into whether that is good or bad, because like so many other things, it depends! But it is quite true that better ideas, products or offerings that come from outside our own definition or context of our set up are not easily accepted by us – very often till it is inevitable to accept them. And this applies, I think, not just to individuals, but to any groups of people where a sense of ownership is established – so it applies to families, communities, cities or countries on the one hand; and perhaps even to departments, functions, companies, business groups on the other. So Sony does not see that IPOD was a better idea than the CD Walkman – perhaps because it was not made here.  Or Microsoft does not see that Google was a great idea till it had to take notice. Our first reaction is – my idea is better than yours. It has its advantages and disadvantages – but the fact remains that in taking this position, we are not rational, mostly irrational.

The same applies sometimes to stocks, bonds, funds and all types of investments too. Often we fall in love with our investments – not because they are great investments, but because we made them. That is also, perhaps, one of the reasons most investors end up choosing their own stocks rather than invest via mutual funds or index funds. The irrational logic (if anything like that exists!) being –  my ideas of choosing a stock are better than yours. While most data suggests that majority of the people cannot beat the market, and the rational thing for most individual investors is to participate in equity through funds, so many people continue to buy their own stocks. That is also one of the reasons, perhaps, why we hold on to our losing investments, simply because we made them.

And finally, on a lighter note, that is, perhaps, also the reason why you may not agree with me on the point of this article. Many of you may tend to think – well this does not apply to me. Because it is not your idea that we are all victims of the “My Ideas are better than Yours” syndrome!

Sunk Costs should not affect decision making

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I had gone for a music concert yesterday evening with my wife. It was a great show – but it rained quite heavily a couple of hours before the show, and there were real chances of the show getting cancelled due to it. While at my house before starting, it was natural for us to think whether the show would happen, and if we should go – specially the distance being long, and traffic chock-a-block while the drizzle had subdued a bit. But the one thing that tilted the decision in favor of going was the fact that we had paid for the tickets in full already.

sunkCostSo what’s the point? Well – the point is that the fact that we had paid for the tickets should not have been the deciding factor. If the rains were heavy, and we had no chances of making it – that alone should have been the criterion. Because the money was gone anyway. It was a different matter that in the end the rain stopped completely, we got there on time despite the traffic, and the show was superb, and hence the risk was worth it – but sometimes it may not work out that way. And even if it does, the reason we took the decision should have been based on whether there was any risk in going or not – rather than because we had paid for the tickets. This is a common ‘sunk cost’ fallacy that a lot of investors are victims of.

Pretty similar situations are likely to arise very often in an investing lifetime. If you are stuck in a situation where a stock you bought falls a lot, assuming you are able to handle the notional fall, your immediate urge is to ‘average the price’ and takes over your thinking. In some cases, it may be the right decision, in fact over time, it may work out and end up being a smart move. But very often, the fact that you bought the stock earlier at a higher price weighs so heavily on you, that you do not evaluate, in enough detail, whether the fundamentals of the company have deteriorated, and if there is a higher risk in buying the stock now, even at the dropped price. There may be real reasons for the fall – and hence averaging out may not be the best strategy. But the ‘sunk cost’ trap comes into play, and affects your decision-making, urging you to average out – rather than buying as a result of a more rational analysis where a purchase at a lower price is deemed to be a sound investment decision irrespective of earlier transactions.

Similarly, assume that you are faced with a situation where you bought stock A and stock B for an equal amount, and a year later, you need 20% of the money invested for some reason. Stock A has gone up 30% and Stock B has fallen 10% by that time. It is likely that you will try to meet your requirements by selling Stock A – simply because you bought it at a lower price and it is 30% up. Again – that may be the ‘sunk cost’ phenomenon at play. The ideal way would be to evaluate the stocks again and then take a call on which one to sell in what quantity. If that is not possible, perhaps selling both to raise an equal amount may be a more rational decision. But the sunk cost paid for the stock weighs so heavily on the mind of the investor that it affects his decision-making, and more likely than not, he will raise money from the stock in which he is in at least some profit.

So what’s the way out of avoiding sunk cost traps? Looking at individual investments in isolation is the problem here – looking at the portfolio as a whole will likely lead to avoiding sunk cost traps. Re-balancing the portfolio (i.e. selling part of your winners and moving them to other assets) is a great long-term strategy, but only if it is set out as a deliberate strategy, and not if it is a result of a sunk cost trap. Hence, it is best if one makes a conscious effort to recognize the sunk cost behavioural trap, and ensure that decision-making is not being affected by the same. Like so many things in investing and finance, unfortunately, there is no clear answer here – on what exactly to do – but it is left best to an investor and his situation to come to a conclusion based on a clear awareness of the possibility of getting into a sunk cost trap.

Why the emotion of loss aversion could kill your returns

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Risk (or uncertainty) in equities is often measured by the degree of volatility. While this is a measure that may have some utility for portfolio management (specially if one has a need to exit positions in case of price drops), I have often felt risk in investing is best measured as the probability of permanent loss of capital. That is because, it is not risk or uncertainty that investors really fear, but losses (notional or permanent) as measured by decrease in capital value that they are afraid of. Any volatility in market prices that does not result in notional losses does not affect the investor (emotionally) precisely because of this tenet.

lossaversionThis is demonstrated aptly by the concept of ‘Loss Aversion’ in behavioral finance – the field of study that analyzes the impact of emotions on investing behavior. The key tenet is that human reactions to the probability of profits and losses are different. We become conservative when faced with profit chances, and take undue risks when faced with prospects of loss.

Consider this scenario – where you have Rs.10,000/- with you, and have to make one of the two choices: (a) Choose a guaranteed gain of Rs.5000/- OR (b) Choose to toss a coin – if its heads, you gain Rs.10,000/- and if its tails, you gain nothing. Which option will you choose?

Now Consider another scenario – where you have Rs.20,000/- with you, and have to make one of the two choices: (a) Choose a guaranteed loss of Rs.5000/- OR (b) Choose to toss a coin – if its heads, you lose Rs.10,000/-, and if its tails, you lose nothing. Which option will you choose?

It is likely for majority of people to choose option (a) in the first scenario, and option (b) in the second scenario. Why is it that in the first scenario, we are not willing to take a chance on more profit, even though we lose nothing, while in the second scenario, we are willing to take a chance to reduce loss, even though we may lose more? That is because, in the first scenario, we have guaranteed profit, so the pleasure we get out of more profit is high, but not as high as the pain we will suffer in case that profit goes away, and we are not fine with the prospect of remaining at status quo. Whereas in the second scenario, we are faced with sure losses, but we are willing to take the chance, even though those losses could actually double, because of the possibility of not having to lose anything. Again the pain of loss is so high, that we take higher risk, just to get back to status quo, even though we could possibly face even higher losses.

lossaversionProspect theory IIISo in case one is unable to keep emotion out of investing, and unable to handle market declines with a calm and rational mind, this is a key emotional or behavioral takeaway that one will do well to remember: we like profits, but we hate losses even more. So when faced with possible losses, we are prone to take higher risks to avoid the possible loss, but when faced with possible gains, we are prone to lock in our gains without taking risks.  Therefore, most investors will end up booking profits early and riding their losses rather than the other way round. Selling losers because the fundamentals have changed is one of the most emotionally painful things for individual investors to do. Well -if you genuinely believe in a company’s earning prospects and valuations and are able to keep your head, it is prudent to hold and even buy more during falls, but one must be aware that – that is the real reason for one’s actions, and not the loss aversion tenet at play.

So, in conclusion, are people risk averse or loss averse? It is not that people do not like risk or uncertainty so much, but it is pretty clear that they hate losses a lot, much more than they love profits. Awareness of this tenet will perhaps help investors to decide truthfully on the best way forward specially during price declines when the stomach is churning and the heart in fear, and use their head to take a rational rather than an emotional decision. As the popular Indian ad says, “Darr Ke Aage Jeet Hai.”

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