Behavioral Finance

The investor’s chief problem-and even his worst

enemy-is likely to be himself.
-Ben Graham
Answer these questions
• A bat and a ball together cost $1.10 in total. The bat costs a dollar
more than a ball. How much does the ball cost?
• If it takes five minutes for five machines to make five widgets, how
long would it take 100 machines to make 100 widgets?
• In a lake there is a patch of lily pads. Every day the patch doubles in
size. If it takes 48 days for the patch to cover the entire lake, how long
will it take to cover half the lake?
The Basics
• Humans suffer from mental pitfalls which lead to poor decision
making.
• Out brains can be thought of composing of
• An Emotional Half
• A Logical Half
• The Emotional Half is our default processor. It produces answers
which are only approximately correct based on similarity, familiarity
and proximity.
• The Logical Half needs effort to invoke. It is slow. It produces precise
answers.
Pitfall-1: The Empathy Gap
• Our ability to predict how we will behave in future is very limited.
• How we imagine we will behave and how we actually do can be very
different.
• Example: 1. Gym and Water Experiment. 2. Typo Deadline
• Decisions taken in the heat of the moment may often be poor
decisions.
• Solution: Pre-commit in ‘cold’ state.
• Application for Investment: Buy when everyone is selling and Sell
when everyone is buying.
Pitfall-2: Loss Aversion
• Humans derive more disutility (pain) from a loss of same amount as
utility (pleasure) from a gain.
• Example: How will you feel if you get a gift of a Rs 5000 footwear.
How will you feel if you have to give someone away your footwear of
Rs 5000?
• Application for Investment: When markets are falling, it is a great time
to buy. However, loss aversion prevents investors from buying in a fall.
• Are you above average in dress sense?
• How many of you think you will finish in top 50% in SAPM?
Pitfall 3: Overconfidence
• Optimism is widely advised.
• Overconfidence arises due to illusion of control/familiarity/high
information/personal involvement and early success.
• Optimism lies in our Emotional Half of the brain. It often gets invoked in
pressure situations. “Ek second me decide kiya, jo hoga dekha jayega”.
• Release of Endorphins hormone when injured.
• Optimism coupled with self-serving bias can be even more harmful.
• Application for Investments: Buying low quality stocks based on their
current earning/performance. Critical thinking is your friend.
Pitfall 4: Expecting Experts to be
Confident
• What kind of a doctor you will visit for a symptom?
• Application for Investment: Be wary of “Tips” and “Confident looking”
investment advisors.
• Expert’s overconfidence often stems from “illusion of knowledge”.
• This overconfidence may lead to wrong decisions: Example: John
Maynard Keynes
• Application for Investment: Do not aim to outsmart all others. Have
an investment philosophy and stick to it with discipline.
Pitfall 5: Folly of
Forecasting/Anchoring
• The track record of forecasting economic cycles is hardly impressive.
• The DCF valuation comes under question mark.
• Why do people forecast then: Well, there is a demand from clients!
• Each morning each news channel has a slot on “Jyotishis”-Religious
Forecasters.
• Why are forecasters needed: The answer may lie in “Anchoring”.
• Investment Application: Discard forecasts and focus instead on what
really matters.
Some other pitfalls
• Information Overload
• Sunk Cost Fallacy
• Evidence before Conclusion OR Conclusion before Evidence.
• This Time is Different
• Etc.
• Etc.
Recommended Reading
• The Little Book of Behavioral Investing- James Montier
• Thinking Fast and Slow-Daniel Kahneman
• Nudge-Richard Thaler