Confessions of

a Value
Investor: A Few
Lessons in
Behavioral
Finance

Sanjay Bakshi
17 March, 2010
Indian Institute of Management
Lucknow

Direct Experience
Vs.
Vicarious Experience

VICARIOUS EXPERIENCE

Extreme
Failure

Mediocrity

Extreme
Success

Most Learning Comes from

Extremes

VICARIOUS EXPERIENCE

All I want to
know is where
Im Going to
Die So I never
Go There

Copy,
Paste,
Emulate
Extreme
Failure

Mediocrity

Ignore

Extreme
Success

Instead of
focusing on
becoming too
smart, i urge
you to focus on
avoiding
foolish
behavior

I urge you to learn from

mistakes of others

Reflexive vs.
Reflective Brain

Reflexive Brain is
effortless, automatic, fast,
can lend itself to errors

Reflective
Brain is
effortful,
reasoned,
slow,
logical, and
less prone
to error

confession # 1
I fell for the
Availability
trap

Human brains tends to drift into

working with whats easily
available to it.

When Im not near

the girl I love, I love
the girl Im near.

The brain cant

use what it
cant
remember...

...or what it is
blocked from
recognizing
under the
influence of
certain
psychological
tendencies

The result? Mind tends to overweigh whats easily available to it

People assess the

frequency,
probability, or
likely cause of an
event by the degree
to which instances
or occurrences of
that event are
readily available
in memory.-Daniel
Kahneman

An event that
evokes emotions
and is vivid, easily
imagined, and
specific will be
more available
than an event that
is unemotional in
nature, bland,
difficult to imagine,
or vague.-Daniel
Kahneman

What sort of
things tend to be
more available
in our minds
than others?

Vivid Events
Recent Events
First Conclusions
Direct Experiences
Anchors
Easily Measurable Data
Information Overload

What are the consequences of overweighing most available information?

Peoples estimates of probabilities
will go wrong, so their estimates of
value will go wrong resulting in
misjudgments.

Key Word: Vivid

Approximately
3,000 people died
in september 11
attacks

An additional
1,500 died due to
increased ROAD
Travel because of
dread risk

What
caused the
dread risk?

Key Word:
Vivid

We under-weigh
rich and
concrete data
because it does
not evoke vivid
images.

Physicians response to
Surgeon Generals report
linking cancer to smoking

The probability that

a physician will
continue to smoke is
directly related to
the distance of the
physicians specialty
from the lungs!

What does
vividness do to
Peoples Perception
of Risk?

We over-react to recent events

Recency + vividness = lethal

combination

Recency

Our most recent experience tends

to carry more weight in our heads
than old experiences.

First-conclusion bias

The human mind

is like the
human egg. Out
of a billion
sperms racing
towards the
egg, only one
succeeds in
entering and
fertilizing it.

As soon as the fastest swimming

sperm enters the egg, the egg
immediately shuts down to stop
any other sperm from entering

We answer
questions which
start with the
word why by
grabbing the
first answer that
comes to mind.

When our minds

jump to
conclusions, we
push aside other
reasons and
latch on to the
first explanation
which comes to
mind

EXample: Steel
Price Hike
Impact on Auto
Stocks

Nothing is more
dangerous than
an idea, when it's
the only one you
have.

mile Auguste Chartier

The human mind

seeks easy
answers to the
questions which
start with the
word why

Why should I buy this stock?

Because its cheap!
Well, so what? Under what
circumstances would this be a
mistake?
Can you think of three reasons
why you could be wrong?

Reason 1: Fraud

Reason 2: value trap

Reason 3: Bubble market

I followed a
golden rule,
namely that
whenever a
new
observation or
thought came
across me,
which was
opposed to my
general
results, to
make a
memorandum
of it without
fail and at
once...

for I had
found by
experience
that such
facts and
thoughts were
far more apt
to escape from
the memory
than
favorable
ones. Charles
Darwin

We overweigh direct experience

and under-weigh vicarious
experience

What we see for ourselves with

our own eyes, hear from our
own ears, has a greater impact
than what we see or hear
through others
I saw it with my OWN Eyes!

Man who syndrome

But I know a man who smoked

three packs of cigarettes a day
and lived to be 99!

Problem of Silent Evidence

You only see the winners!

We have never seen anything like

this, said analyst Glenn Schorr, who
covers the investment banks for UBS
AG. There have been tough situations
like Long-Term Capital Management and
the crash of 1987, but the problem
here is there is leverage in the
securities under the microscope and in
the banks that own them. And to try
and unwind it all at once creates a oneway market where there are only
sellers, and no buyers. - WSJ,
September 14, 2008

What we learn from history, is

that we dont learn from
history. Benjamin Disraeli

Anchoring

Money lost
in wallet

Anchors
Par value
52 week low
All time high
Low absolute price
Sunk-costs
Stock price itself

Overweighing what can be counted

Youve got a complex system and it spews out

a lot of wonderful numbers that enable you to
measure some factors.

But there are other factors that are terribly

important, [yet] theres no precise numbering
you can put to these factors...

You know theyre important, but you

dont have the numbers.Well practically
everybody (1) overweighs the stuff that
can be numbered, because it yields to
the statistical techniques theyre taught
in academia...

and (2) doesnt mix in the

hard-to-measure stuff that may
be more important. That is a
mistake Ive tried all my life to
avoid, and I have no regrets for
having done that.

To a Man with a Hammer,

everything looks like a nail.

The first step

is to measure
what can be
easily
measured. This
is okay as far
as it goes.
John Bogle

The second step

is to disregard
that which
cannot be
measured, or
give it an
arbitrary
quantitative
value. This is
artificial and
misleading.

The third
step is to
presume
that what
cannot be
measured
really is
not very
important.
This is
blindness.

The fourth
step is to say
that what
cannot be
measured does
not really
exist. This is
suicide.

Not everything
that counts can
be counted, and
not everything
that can be
counted, counts.
Albert Einstein

Example Beta as a
measure of risk

People calculate too much and

think too little.

Example 1

Cost of machinery:
Rs 10 cr.
Expected life of
machine: 10 years
Annual savings: Rs
2.50 cr. p.a.
Expected residual
value of the
machine: Rs 1 cr.
Cost of capital: 15%
p.a.
Accept or reject?

Accept or reject?

How did
he Solve
this
Problem?

Warren Buffett

He shut down the

textile business of
Berkshire
Hathaway!

Huh?

The domestic textile industry

operates in a commodity business,
competing in a world market in
which substantial excess capacity
exists.

Much of the trouble we experienced

was attributable, both directly and
indirectly, to competition from
foreign countries whose workers are
paid a small fraction of the U.S.
minimum wage...

Over the years we had the option of

making large capital expenditures in
the textile operation that would have
allowed us to somewhat reduce
variable costs... Each proposal to do so
looked like an immediate winner...

Measured by standard return-on-investment

tests, in fact, these proposals usually
promised greater economic benefits than
would have resulted from comparable
expenditures in our highly-profitable candy
and newspaper businesses...

But the promised benefits from

these textile investments were
illusory...

Many of our competitors, both domestic

and foreign, were stepping up to the
same kind of expenditures and, once
enough companies did so, their reduced
costs became the baseline for reduced
prices industrywide...

Viewed individually, each

companys capital investment
decision appeared cost-effective
and rational..

Viewed collectively, the decisions

neutralized each other and were irrational
(just as happens when each person watching
a parade decides he can see a little better if
he stands on tiptoes)...

After each round of investment,

all the players had more money in
the game and returns remained
anemic.

Thus, we faced a miserable choice:

huge capital investment would have
helped to keep our textile business
alive, but would have left us with
terrible returns on ever-growing
amounts of capital...

After the investment, moreover, the

foreign competition would still have
retained a major, continuing advantage
in labor costs...

A refusal to invest, however, would

make us increasingly non-competitive,
even measured against domestic textile
manufacturers...

[Buffett] knew that the huge

productivity increases that
would come from a better
machine introduced into the
production of a commodity
product...

would all go to
the benefit of the
buyers of the
textiles. Nothing
was going to [come
to us] as owners...

Thats such an obvious

concept that there are all
kinds of wonderful new
inventions that give you
nothing as owners...

except the
opportunity to
spend a lot
more money in
a business
thats still
going to be
lousy...

The money still wont come

to you. All of the
advantages from great
improvements are going to
flow through to the
customers...

Conversely, if you own the only

newspaper in [town] and they were
to invent more efficient ways of
composing the newspaper...

then when you got

rid of the old
technology and got
new, fancy
computers and so
forth, all of the
savings would
come right through
to the bottom
line...

In all cases, the

people who sell the
machinery and even
the internal
bureaucrats urging
you to buy the
equipment...

show you
projections
with the
amount youll
save at
current prices
with the new
technology...

However, they
dont do the
second step of
the analysis
which is to
determine how
much is going to
stay home and
how much is just
going to flow
through to the
customer

Ive never seen a

single projection
incorporating
that second step
in my life. And I
see them all the
time...

Rather, they
always read: This
capital outlay
will save you so
much money that
it will pay for
itself in three
years

So you keep
buying things
that will pay for
themselves in
three years

And after twenty years of doing it,

somehow youve earned a return of
only about four percent per annum.
Thats the textile business...

And it isnt that

the machines
werent better.
Its just that the
savings didnt go
to you...

The cost reductions

came through all
right. But the
benefit of the cost
reductions didnt go
to the guy who
bought the
equipment...

Its such a simple idea. Its so

basic. And yet its so often
forgotten.

People calculate too much and

think too little.

Example 2

Assume today is 27 March

2009 i.e. there are only
five days left in the
financial year ending on 31
March 2009. One of your
friends has approached you
to advice him on his
investments. He presents
you with the following data
about his current
portfolio:

In addition, your friend also tells you that

during 2008-09, he has already realized short-term
capital gains of Rs 27 lacs. He now needs Rs 73
lacs by selling part of his portfolio. Which
stocks should he sell?

Selling Hersheys and Godiva

could be very silly mistakes!
Why?

People calculate too much and

think too little.

Noise
Overreaction
to what you
see
Quantity not
as important
as quality

Information
Overload =
Noise
I saw it with my OWN Eyes!

My experience with Goldman Sachs

Price is readily available and precise

and is also recent and vividly shown on
TV etc.

Value is not readily available and is

necessarily an estimate
Is it any wonder people overweigh
price?

Antidotes
Look for
disconfirming
evidence killing
your own ideas

Under-weigh extravivid experience and

overweigh less vivid
experience.
Same with recent
events; i.e. cool off.

Remember the lesson: An

idea or a fact is not worth
more merely because it is
easily available to you.

confession # 2
I let
Perceptual
contrast
misguide me

Two types of
contrast effect
high contrast
low contrast

Scene from Tin Men

Dan Airely

Dan Airely

Decoy

What will happen if you put this in

your mouth and then...

and then you put this in your

mouth?

Buying a Lamp

Buying a Car

Is a Rs 15 stock really cheaper

than a Rs 500 stock?

Ignoring the role of transaction

costs and taxes on long-term
returns

How would the Buy-and Hold Strategy do?

Blind averaging down- Its fallen

so much, how much lower can it
go?
Answer: 100%
Throwing good money after bad

If you put a frog in

boiling hot water, it
will instantly jump
out and escape

But if you put a frog in lukewarm

water and slowly boil it, it will
slowly boil to death!

Boiling frog effect is a

frequent cause of business
failure
Cognition, misled by tiny
changes involving low
contrast, will often miss a
trend that is destiny.

What did
digital camera
do to the
photographic
film business?

What did the mobile phone do to

the fixed line telephony
business?

What did the Audio CD do to the

audio cassette business?

Slow change goes unnoticed

Example: SAIL 2003 vs. SAIL
2007
Learn to focus on a few key
factors which may be
changing slowly

confession # 3
Failure to
promptly
resolve
cognitive
dissonance

Cognitive
Dissonance as
the Engine
Behind Self
Justification

How do Smokers Rationalize?

The medical evidence is

inconclusive

Other smart people do

it so it cant be all
that bad!

But I know a man who smoked

three packs of cigarettes a day
and lived to be 99!

Its needed for my relaxation- I

might have a shorter life but it
will be more enjoyable!

Man is not a rational animal

He is a rationalizing one

Lesson?
Ask if you
are
inventing
new
reasons to
rationalize
your
behavior?

Confirmation
Bias:
Overweighing
evidence that
confirms
your prior
notions and
under
weighing
evidence that
contradicts it

Its in the nature of things,

that if you look hard enough
for evidence that support
your belief, you will find it.
And that will intensify your
belief...

Francis Bacon

What a man believes, he prefers to

be true.

Proposition: All Swans are

White
How will you prove it?

Proposition: All Swans are

White

Confirmation
Bias:
Role of
Surprise

People are too slow to change an

established view
Importance of Surprise

Need to change
your mind in
light of new
facts which
change the
odds

John M Keynes

When facts change, I

change my mind. What
do you do Sir?

The
Justification
of Effort

If a person works
hard to attain a
goal, that goal
will be more
attractive to the
individual than it
will be to
someone who
achieves the same
goal with little or
no effort. - Elliot
Aronson in The
Social Animal

Sunk cost fallacy - I have

too much invested in this
situation to walk away now
I cant afford to write this
off.
Maybe you can

Capital
(mis)allocation
decisions
Traditional Budgeting
vs. Zero based
budgeting

The
Endowment
Effect

Possessions are over-valuedonce owned they suddenly

become worth more to the
owner than he would pay for
them if he did not own them
already Endowment Effect

One Mans Ceiling is Another Mans Floor

Mans decisions are suddenly

regarded by him as better
than was the case just before
he made them

confession # 4
I gave into
social proof

Video Clip on Salomon Asch Experiment

WE RELY
HEAVILY ON
PEOPLE
AROUND US
FOR CUES ON
HOW TO
THINK, FEEL,
AND ACT

Video Clip on Elevator Experiment

Social proof most

influential under
two conditions

Uncertainty and
doubt when
people are unsure,
when the situation
is ambiguous, they
are more likely to
copy others

SimilarityPeople follow
the lead of
similar others
Of Suicides and
Lost Wallets

PERSUASION VERY EFFECTIVE IF IT

COMES FROM PEERS
PEOPLE FOLLOW LEAD OF SIMILAR
OTHERS

TESTIMONIALS
FROM SIMILAR
OTHERS

Video Clip on Safety in Numbers

Hardwired to HERD
Real pain and social pain are
felt in the same parts of the
brain.
Eisenberger Lieberman study

Eisenberger Lieberman study

Similar
Others

Herding in
Money
Management

Zebras have the same problems as

institutional portfolio managers.
First, both seek profits. For
portfolio managers, above-average
performance; for zebras, fresh
grass...

Secondly, both dislike risk.

Portfolio managers can get
fired; zebras can get eaten by
lions...

Third, both move in herds. They

look alike, think alike and stick
close together...

If you are a zebra, and live in a

herd, the key decision you have to
make is where you stand in
relation to the rest of the herd...

 When you think that the conditions

are safe, the outside of the herd is
the best, for there the grass is fresh,
while those in the middle see only
grass which is half-eaten or
trampled down...

The aggressive zebras, on the

outside of the herd, eat much
better...

On the other hand or other hoof

there comes a time when lions
approach. The outside zebras end up
as lion lunch, and the skinny zebras
in the middle of the pack may eat
less well but they are still alive...

A portfolio manager for an institution

such as a banks [wealth management]
department cannot afford to be an
Outside Zebra. For him, the optimal
strategy is simple: stay in the centre of
the herd at all times...

As long as he continues to buy the

popular stocks he cannot be faulted.
To quote one portfolio manager, It
really doesn't matter a lot to me what
happens to Johnson & Johnson as long
as everyone has it and we all go down
together....

But on the other hand, he

cannot afford to try for large
gains on unfamiliar stocks
which would leave him open to
criticism if the idea fails...

Needless to say, this

Inside Zebra philosophy
doesn't appeal to us as
long-term investors.. We
have tried to be Outside
Zebras most of the time,
and there are plenty of
claw marks on us."

John Templeton

People are always asking me

where is the outlook good,
but thats the wrong
question...

The right question is: Where

is the outlook the most
miserable? I call this the
Principle of Maximum
Pessimism...

Let me explain how it works.

In almost every activity of
normal life people try to go
where the outlook is the
best...

You look for a job in an

industry with a good future, or
build a factory where prospects
are best. But my contention is if
you are selecting publicly
traded investments, you have to
do the opposite...

Youre trying to buy a share

at the lowest possible price in
relation to what that
corporation is worth...

And there is only one reason

a share goes to a bargain
price: Because other people
are selling. There is no other
reason...

To get a bargain price, youve

got to look for where the
public is most frightened and
pessimistic.

You pay a very high price in

the stock market for a
cheery consensus.

confession # 5
I became a
dope addict

Video on Dopamine

Cocaine causes dopamine

increase resulting addictive
pleasure.
Operant Conditioning: It feels
so good, I want more more
more!!!

Neuroecon
omics:
There is
no
difference
between a
man who
who just
made a
killing in
the
markets
and a man
who is
high on
cocaine

Dot Con Video Clip - Dope Addicts?

Getting
what you
expected
produces
no
dopamine
kick

However,
an
unexpected
gain fires
up the
brain
(neurons
go from
firing 3
times a
second to
40 times a
second)

If expected
reward
fails to
materialize,
dopamine
dries up

Unexpected pleasant surprises

make people ecstatic because of
the dopamine surge they produce

If lab rats are wired up to receive

tiny pulses of electrical stimulation
in the dopamine centers of the brain
when they press a lever...

...they often begin tapping it nonstop

to the exclusion of other activities,
including eating and drinking...

They would rather starve to death

than live without that dopamine
surge inside their brains.

The human equivalent of this Lab

Rat is there in all of us...

Dopamine
system
loves
novel
stimuli.
Glamor
stocks

Variety is
the spice
dope of
[market]
life
IPOs
New Hot
Stocks e.g.
dotcoms

Severe change and

exceptional returns
usually don't mix. Most
investors, of course,
behave as if just the
opposite were true...

That is, they usually

confer the highest priceearnings ratios on exoticsounding businesses that
hold out the promise of
feverish change...

That prospect lets

investors fantasize
[THINK DOPAMINE]
about future
profitability rather
than face today's
business realities.
For such investordreamers, any blind
date is preferable
to one with the girl
next door, no
matter how
desirable she may
be.

We make bricks in Texas

which use the same process as
in Mesopotamia. - Charlie
Munger

Just like in video games, vivid stock market

screens and real time charts offer
frequent change (i.e. volatility) and
sometimes unexpected good surprises,
thereby producing surges of dopamine
which results in addiction

Investment success will not

be produced by arcane
formulae, computer
programs or signals flashed
by the price behavior of
stocks and markets....

... Rather an investor will

succeed by coupling good
business judgement with an
ability to insulate his thoughts
and behavior from the super
contagious emotions that swirl
about the marketplace.

Monetary gains have narcotic

power

Addicted gamblers
chain themselves
to slot machines
Using adult
diapers

People are most credulous when

they are most happy- Walter
Bagehot
They become extremely suggestible
and will believe almost anything

confession # 6
I became
foolishly
overconfident

A person in a manic state is impulsive,

turbocharged with euphoria, often unable
to sleep, and endowed with a grand ability
to perceive the underlying significance
of everything around him

I am on a roll- I can see the

future, nothing can stop me - I am
the master of the universe

Elevated levels of dopamine of a man

in a hot state makes him
overconfident.

One-time gains start looking like

perpetuities, luck becomes skill, and
early retirement is just around the
corner...

Normal human
tendency
90% of drivers
think that they
are better than
average drivers

Why do people buy lottery tickets?

Or indulge in day trading?

74% of investors in a survey

said that their own funds
will consistently
outperform the market
Reality? Only a handful
actually do

Only 37% of managers

believe that mergers create
value for buyers. But when
it came to their own mergers
and acquisitions, 58% said
their deals will create value

Overoptimism in Predictions

Our track record in making

predictions is very bad
The future is very
unpredictable

Oil at $140?

Oil at $10?

The value of ONGC when Oil

is at $10 will be VASTLY
different from its value
when its at $140

We do not have an opinion

about where the stock market,
interest rates, or business
activity will be a year from
now. We've long felt that the
only value of stock forecasts
is to make fortune tellers
look good. We believe that
short-term market forecasts
are poison and should be kept
locked up in a safe place, away
from children and also from
grown-ups who behave in the
market like children.

If I taught a
course in
investments, my
final exam would
be to value this
Internet stock.

And if they came

up with an
answer, they'd
flunk. And if
they came up with
a blank sheet of
paper, I'd
probably give
them a B.

And if they said

how the hell
could you ask
something so
dumb? Id give
them an A.

There are
two classes
of
forecasters:
Those who
don't know
and those
who don't
know they
don't know.

John Galbraith

I have never seen a research

report which says:
The value of this is 1,000 if this
happens and 50 if something else
happens, and I have no clue what
will happen.
Importance of Plausible Range
of Values

Financial modelers use

scenario analysis and then
apply subjective
probabilities to each
scenario to arrive at the
expected value

Thats the functional equivalent of

the statistician who drowned in
water which was, on average, only
4 feet deep!

He forgot that the RANGE of

depth was between 2 feet and
10 feet!

Nassim Taleb

The worst case scenario is

often more consequential
than the forecast itself.

Two very
different
reactions to
worst case
scenarios

Available
worst casescenarios
results in
ignorance of
frequency and
overweighing of
magnitude.
Consequence:
Excessive
Overreaction

Available worst casescenarios results in ignorance

of frequency and overweighing
of magnitude.
What is most available?
Personal vs. Vicarious
experience
Recency
Vividness
e.g. Terrorism vs Climate Change

Immediately after a horrible

scenario (e.g. terrorist attack,
major market crash), peoples
perception of risk goes through
a major change.

If worst case
scenario is
unavailable
there is a tendency
to assume that the
frequency is as
good as zero
Consequence:
Utter Neglect
e.g. Terrorism vs
Climate Change

It hasnt
happened for a
long time, so it
wont happen
Earthquake and
volcano
eruptions
LTCM

In all my
experience,
Ive never
been in an
accident of
any sort
worth
speaking
about. I have
seen but one
vessel in

I never saw a
wreck and have
never been
wrecked nor was
I ever in any
predicament that
threatened to
end in disaster
of any sort.- E.J.
Smith, 1907,
Captain, RMS
Titanic

The Expected Value Frame of

Mind

Take the probability times the

amount of possible loss from the
probability of gain times the amount
of possible gain. that is what we are
trying to do. its imperfect, but that's
what it is all about.

Frequency-Magnitude

Much of humanity focuses on

frequencies and not magnitudes
and expected values

When odds of success are low

(and for entrepreneurs they are
ALWAYS low)
OMG, this is too tough!
I cant do it!
But, what are the consequences,
if you succeed?

Understand the
importance of
black swans

Along the hilly slopes of the bell

curve, most values are clustered
around the middle. The average value
is also the most common value.

The points along the far extremes of the

curve contribute very little statistically.
If 100 random people gather in a room and
the world's tallest man walks in, the
average height doesn't change much.

But if Bill Gates walks in, the average net worth

rises dramatically. Height follows the bell
curve in its distribution. Wealth does not: It
follows an asymmetric, L-shaped pattern known as
a power law, where most values are below
average and a few far above. In the realm of the
power law, rare and extreme events dominate the
action.- David Shaywitz

Bell curve driven models under-estimate

the importance of black swans - positive
(windfalls), as well as negative
(disasters).

If its not worth doing at all its

not worth doing well. - Charlie
Munger

It is not given to human beings to have

such talent that they can just know
everything about everything all the time.
But it is given to human beings who work
hard at it who look and sift the world
for a mispriced bet that they can
occasionally find one.

And the wise ones bet heavily

when the world offers them
that opportunity. They bet big
when they have odds. And the
rest of the time, they don't.
It's just that simple.

You only have to get rich

once.
- Warren Buffett

facing your first failure

But failure is a just a stepping
stone and not a stumbling block,
isnt it?
How many successful
entrepreneurs got it right the
first time?
So you embrace failure

Michael Jordan Commercial

26 times Ive been entrusted to

And that
why,over,
I succeed
Ive failed
over,isand
and
Ive
lost
almost
300 games
take
the
game-winning
shot.
Ive
missed
more
than
9,000
over again in my life
And
shots
inmissed
my career

Some people just dont give up

confession # 7
I did not think
carefully
about losses

Rules:
1. Highest
bidder wins
Text

2. 2nd
highest
bidder also
has to pay
his bid price
to the
auctioneer.

HUH?

Deprival Super
Reaction Syndrome
(DSRS)

If you deprive
me, Ill have a
super reaction!

The quantity of a mans pleasure from

a ten-dollar gain does not exactly
match the quantity of his displeasure
from a ten-dollar loss.

Video on Loss Aversion

People tend to accept more

risk to avoid losses than to
obtain equivalent gains

DSRS also takes place when you

almost have something you love
and you lose it [near-misses]

What happens to our risk assessment

ability when, as we approach, the green
light turns yellow?

We become crazy gamblers!

People feel
considerably
more pain after
incurring a
financial loss
than they feel
pleasure after
achieving an
equivalent gain

In the extreme
case, desperate
fears after
losing a lot of
money induces
people to take
enormous risks
with the rest of
their money Gamblers ruin

Countdowns make
people go crazy!

Closing Bell Effect

I am gonna miss it!

Neuroeconomics
shows that
financial losses
and mortal
danger are
processed in
the same part of
the brain:
Amygdala

Basic
Instinct

3 types of subjects were chosen

to play a game: normal brains,
damaged amygdalas, brains
damaged in areas other than
amygdala (controls)

Each player was given a starting

capital of $20 and was then
offered a choice to play a game or
not. The game involved a coin
toss. To play the game one had to
invest $1

Heads, you lose$1

Tails, you win $2.5
Total number of rounds: 20
What would you do?

Damaged amygdalas played 84% of the

rounds
Normals played 63%
Controls played 61%

Damaged amygdalas did much

better than the other two
groups!
Why?

Fear of losing our MTM

profits makes us sell out of
good decisions too early.
The stupidity of you cant
go broke taking a profit.

confession # 8
I became a
pavlovian dog

How to Create a Misassociation?

The human equivalent of pavlovian
dog is there in all of us

Restaurants stopped serving

tandoori items and sale of
tandoors plunged...

High price
associated
with high
quality
e.g.
Nakshatra
diamonds
made by De
Beers

Advertisers demonstrate the power of

positive associations by constantly
connecting their products with the things
we like.

=
In a world where for many the
acquisition of money is difficult...
the possession of it in large amount
seems a miracle. Accordingly,
possession must be associated with
some special genius.- Galbraith

Mis-associating good outcomes

with skill (stock market swindle,
massively outperforming fund
etc.)
Mis-associating bad outcomes with
bad process
Under-appreciation of role of
luck

You see success, and you ask what caused

it?

You read success stories and you

look for what they have in common

You dont learn about

winning by only looking
at winners!

Stock market
Predictions SCAM
Lotteries

You dont learn about

success by only looking
at successful people

When people tend to like what

other people like, differences in
popularity are subject to what is
called cumulative advantage,
or the rich get richer effect.
This means that if one object
happens to be slightly more
popular than another at just the
right point, it will tend to
become more popular still...
Darwins Theory of Evolution

As a result, even tiny, random

fluctuations can blow up,
generating potentially enormous
long-run differences among even
indistinguishable competitors...

Thus, if history were to be somehow

rerun many times, seemingly
identical universes with the same
set of competitors and the same
overall market tastes would quickly
generate different winners:
Madonna would have been popular
in this world, but in some other
version of history, she would be a
nobody, and someone we have never
heard of would be in her place.

Parallel Universes

Web-based experiment.
More than 14,000 participants
registered at Music Lab
(www.musiclab.columbia.edu), and
were asked to listen to, rate and,
if they chose, download songs by
bands they had never heard of.

Some of the participants saw

only the names of the songs and
bands, while others also saw how
many times the songs had been
downloaded by previous
participants. This second group
social influence condition
was further split into eight
parallel worlds such that
participants could see the prior
downloads of people only in
their own world.

All the artists in all the worlds

started out identically, with
zero downloads but because
the different worlds were kept
separate, they subsequently
evolved independently of one
another.
Darwins Theory of Evolution

At the same time, however, the

particular songs that became hits
were different in different
worlds, just as cumulativeadvantage theory would predict.
Introducing social influence
into human decision making, in
other words, didnt just make the
hits bigger; it also made them
more unpredictable.

Summary

confessions:
1.Availability
2.Perceptual
Contrast
3.Cognitive
dissonance
4.social proof
5.Dopamine addiction
6.Overconfidence
7.Losses
8.Pavlovian
Misassociation

Instead of
focusing on
becoming too
smart, i urge
you to focus on
avoiding
foolish
behavior

I urge you to learn from

mistakes of others
After all...

You don't have

to pee on an
electric fence
to learn not to
do it.- Charlie
Munger

Thank You