Hedonic Treadmill

Another barrier to raising your level of happiness is the hedonic treadmill, which
causes you to rapidly and inevitably adapt to good things by taking them for granted. As
you accumulate more material possessions and accomplishments, your expectations
rise. The deeds and things you worked so hard for no longer make you happy; you need
to get something even better to boost your level of happiness into the upper reaches of
its set range. Good things and high accomplishments, studies have shown, have
astonishingly little power to raise happiness more than transiently: In less than three
months, major events (such as being fired or promoted) lose their impact on happiness
levels. Wealth, which surely brings more possessions in its wake, has a surprisingly low
correlation with happiness level.

Rich people are, on average, only slightly happier than poor people. Real income has
risen dramatically in the prosperous nations over the last half century, but the level of
life satisfaction has been entirely flat in the United States and most other wealthy
nations. Recent changes in an individuals pay predict job satisfaction, but average
levels of pay do not. But once you get the next possession or achievement, you adapt to
it as well, and so on.
By failing to anticipate the extent of our hedonic adaptation, as consumers we routinely
escalate our purchases, hoping that new stuff will make us happier. Indeed, a new car
feels wonderful, but sadly, the feeling lasts for only a few months. We get used to
driving the car, and the buzz wears off. So we look for something else to make us
happy: maybe new sunglasses, a computer, or another new car. This cycle, which is
what drives us to keep up with the Joneses, is also known as the hedonic treadmill.

An illustrative study of this principle was conducted by David Schkade and Danny
Kahneman. They decided to inspect the general belief that Californians are happier
after all, they live in California, where the weather is usually wonderful.* Somewhat
unsurprisingly, they found that midwesterners think that fair-weather Californians are,
overall, considerably more satisfied with their lives, while Californians think that
midwesterners are considerably less satisfied overall with life because the latter have to
suffer through long, subzero winters. Consequently, people from both states expect that
a Chicagoan moving to sunny California will see a dramatic improvement in lifestyle,
while the Angeleno moving to the Midwest will get a dramatic reduction in happiness.

How accurate are these predictions? It turns out that they are somewhat accurate. New
transplants do indeed experience the expected boost or reduction in quality of life due to
the weather. But, much like everything else, once adaptation hits and they get used to
the new city, their quality of life drifts back toward its premoving level. The bottom line:
even if you feel strongly about something in the short term, in the long term things will
probably not leave you as ecstatic or as miserable as you expect
Confirmation Bias
Going through a tough breakup? Sadly, every song on the radio is about heartache. As
if somebody told the RJ that you were listening. Or on a more positive note, you are in
love and somehow every song is romantic!

The phenomenon explained above doesnt stay in its natural occurrence. Human beings
have a natural propensity to take this illusion from its passive existence to an active
pursuit and the result is that rather than waiting for things to appear more frequent you
start looking for them.
Psychologists call this as Confirmation Bias.

The first plausible answer that the mind finds to a question becomes the near-truth and
there is a natural resistance to seek more answers and accept it as a conclusion.

This is popularly known as the first conclusion bias.

Just like a vicious circle, the very act of this selective seeking of supporting evidences
makes the initial ideas even more prominent till a point we are absolutely convinced that
nothing else is truth.

This is what I introduced above as Confirmation bias.

3 reasons we fall for Availability Bias

Reason #1 Recent activity: Something which is more recent occupies more recalling
power in the brain compared to something that happened long ago and hence we tend
to weigh that activity as more important than others.
For example, your tendency to go in a train after a train blast (unless you absolutely
have to) is extremely low immediately after a bomb blast.

For example, consider a series of 20 coin flips that have all landed with the heads side
up. Under the gamblers fallacy, a person might predict that the next coin flip is more
likely to land with the tails side up.
Reason #2 Personal Experience: Something which has happened to us is easy to
recall compared to something which has not. Since your all senses are involved in
personal experiences, the impression in the memory is significant and hence its easily
recallable.
Reason #3 Vividness: The more vivid the thing, the easier it is to recall for the brain.
The technique (vividity) which works as a brilliant memory tool, ironically, also acts as
an impediment in logical reasoning due to our tendency to overweigh the importance of
a vivid event compared to a not-so-vivid event.
Availability bias and investing
First, lets understand how an investors suffers because of this When-I-am-not-near-
the-girl-I-love, I-love-the-girl-I-am-near fallacy and then see what can be done to avoid
it.
The most common behaviour is observed in the panic/euphoric markets. A recent event
causing a sudden reaction in the markets, like a terrorist attack causing a crash are the
example of this bias.At times like these, it is imperative for investors to take themselves
mentally away from the scene and think objectively as to why the value should be
affected.

We all know that value is affected only by two variables (1) Cash flows and (2) Interest
rates.

If there is no reason for these two to change, there is no reason for prices to change.
These markets create opportunities for rational investors. Another way this bias affect
us is during the evaluation of business prospect. We have a natural tendency to give too
much importance to the current or past few quarters.

The reason is simple, the experience of those quarters is very recent and its easy for us
to recall that straight away. Combine this with the vividness provided by business
channels and experts telling you day in and day out whats great or bad about the
company and that makes you overoptimistic or over-pessimistic about the prospects.
Even the contrarian in you sometimes may feel overwhelmed and succumb to they
must know something I dont syndrome.
This can be avoided by taking a longer operating history of the business while
evaluating it. Almost every prominent investor has emphasized this fact. Look for a long
operating history preferably 10 years or more. In a lot many Indian companies, 10 years
history may not be available, but take as much as you can and then evaluate the
business.

Important: I am not asking you to ignore the recent quarters. The aberration in recent
quarter results may or may not be just aberrations.
Structural changes are also very subtle. But the idea is to look the picture from both far
off (10 years) and close (recent quarters) without over-emphasizing any view.
Another way in which availability bias impacts investors is the tendency to give too
much importance to an idea (lets take a stock idea for e.g.), the moment it strikes to us.
The sources of the idea may differ. You may have heard about a company from an
intelligent friend or a known stock picker or worse, a TV stock expert and you work on it
and you agree with the prospect.

Now dont get me wrong here! Its good to be excited about something you just
discovered. I am just pointing out to the fact that the tendency is to give too much
importance to the one idea. After all, the stock doesnt know we own it.

Always remember

An idea or a fact is not worth more merely because its available to you.
The examples are many, like:
 Overoptimistic about upcoming IPO because your previous IPO investment made
money, completely disregarding the fact that in general IPOs have been losing
propositions for investors.
Selling a security just because it has risen up substantially in the recent times
without giving the regard to the value-price gap.
Buying something just because it has fallen 80% from the peak. (this is also called
anchoring bias but I will discuss it later)
Giving too much importance to price movement of recent past.
Giving too much importance to stocks that are covered by the media and ignoring
the ones those are not.
And so on..

But what can rational investors do to deal with this bias?

The solutions have to be customized according to the investor. But here is a general
broad guideline which have helped number of investors and which I have found very
helpful personally.

Since most of the biases are psychological, unless you are trained to think about them
yourself, a written reminder is of utmost use. Infact, we can almost remove all
inefficiencies from our thinking process if we follow written procedures (general
guidelines).

This idea has been very well explained by Atul Gawande in his book The Checklist
Manifesto and the strong idea of checklists have been used and promoted by very
savvy investors including Buffett, Munger, Mohnish Pabrai, and Guy Spier.
As a defense against our cognitive disability of remembering everything, checklists
help us avoid first conclusion bias. But always remember, the effectiveness of the
checklist will be determined not only by its existence but by its exhaustiveness and its
ability to accumulate your learning, be it direct or vicarious.

As Buffett have told us a number of times

An investor needs to do very few things right as long as he or she avoids big mistake.

Expert Generalists
Expert-generalists study widely in many different fields, understand deeper
principles that connect those fields, and then apply the principles to their core
specialty.
That struck a chord with me because that is what good venture capitalists do. In his
book The Second Bounce of the Ball, Ronald Cohen, who has a good claim to being the
first true VC here in the UK, wrote:
[investors] have to be financially trained and to have an understanding of
management, but you also have to have a strategic brain while being sensitive to
tactical and people issues
To that I would add empathy, patience, grounding, creativity and hustle. So we have to
be generalists in that sense. Then on top of that we need to master multiple areas of
investment at least if you are to have a long career. In my seventeen years in this
industry, I have invested in enterprise software, semiconductors, SaaS, social media,
adtech, and ecommerce across multiple sectors. That has required a lot of reading!
Then right now I am getting to grips with Bayesian Networks, Hidden Markov Models,
Convolutional Neural Networks and back propagation as Forward Partners investigates
whether to have a big push in what we are currently calling Applied AI. Further, all of
this applies across multiple industries, from fintech to fashion to healthcare (one of my
colleagues is up to his neck in microbiome research as we speak).
You can see the need to be an expert-generalist.
All this begs the question of how one becomes an expert-generalist, or if you are
already an expert-generalist, how you become a better one.
The answer is to get good at learning. Fortunately Sims spells it out for us. Here is what
he describes as Musks two stage process for learning:
1. Grasp the fundamental principles
2. Reconstruct those fundamental principles in new fields
There are no short cuts here. Musk used to read 60 books per month. But when, and
only when, you understand the fundamentals you can more quickly learn and apply
things in new areas. Returning to AI Bayesian Networks are much easier to
understand if you grasp the fundamentals of statistics, and once you grasp the
fundamentals of Bayesian Networks (and all the other components of AI) it is much
easier to understand where they can be successfully employed and where they cant.
Similarly with regard to human behaviour, a solid grasp of behavioural psychology
makes it easier to predict how people will react to new products and services.
And getting good at learning isnt just important for VCs. Its important for everybody.
The world is changing so fast now that one area of knowledge is most unlikely to be
enough to build a career. A quick look at this Wikipedia article on the history of
programming languages shows what developers have to deal with, but something
similar is true for just about everyone else.

Advantages & Disadvantages of Commissioned Sales

Commission is a pay format where salespeople receive a percentage of the amount of
their sales as income. For instance, a 5 percent commission on a $100 sale means you
get $5 of income for the sale. Commission sales are common for salespeople and they
are intended to motivate higher sales.
Reward for Performance

For employees, the main benefit of commission pay is that it rewards those employees
that perform well. The company also sees the benefit in motivating employees toward
higher performance by aligning pay with production. Employees that challenge
themselves and set higher goals will more likely push themselves to achieve those
goals if it means more pay. Commission also helps employees avoid the potential for
conflict that comes when higher performing employees receive the same pay as lower
performers.

Payroll Planning

Commission pay can benefit your business because it means your payroll costs are
largely tied to the business your receive. While you pay more to higher-performing
employees, the reason they earn more is because they drive more sales for your
company. Some employers give periodic raises to employees without seeing any
additional results or performance increases as a result of the pay increase. Commission
and sales are naturally linked.

Short-Term Orientation

A concern with commission sales is that they may motivate salespeople to push harder
for sales in the short term. High-pressure or manipulative sales approaches can often
produce short-term sales, but they also tend to drive customers away over time. Thus,
companies need to consider building commission structures that motivate employees
toward long-term sales relationships. This may mean setting up some level of
commission to reward repeat sales or increased performance with key customers.

Expectations

Finding a perfect commission rate that motivates salespeople but keeps labor costs
under control is critical. If the company sets a commission rate that is too high initially,
its payroll expenses may be high relative to the profits derived from higher levels of
sales performance. The challenge comes trying to convince employees that it is better
for the business and for them that the company lower commission or change the pay
structure to adjust.

Incentive Caused Bias

Jana Vembunarayanan / April 15, 2013
I am starting this post with an Excerpt From Seeking Wisdom From Darwin To Munger
The organizers of a tennis tournament needed money. They approached the CEO of
TransCorp and asked him to sponsor the tournament.

How much? asked the CEO.

One million, said the organizer.

That is too much money, said the CEO.

Not if you consider the fact that you personally can play one match, sit at the honorary
stand next to a member of the presidential family and be the one that hands over the
prize, said the organizer.

Where do I sign? said the CEO.

People do what they perceive is in their best interest and are biased by incentives. I
encountered this when I was in high school. Some of the teachers in the school I
studied, offered private classes to their students. The money they got by taking private
classes sometimes exceeded their salary. Now you can imagine what could have
happened to those students who did not join the private classes? They were given
impositions, insulted in front of others and were graded poorly in the exams. Those who
took the private classes got good grades and did not encounter any issues. I always
wondered why this practice was allowed.
Charlie Munger in his famous speech The Psychology of Human Misjudgment
explains

The power of incentives to cause rationalized, terrible behavior is also demonstrated by

Defense Department procurement history. After the Defense Department had much
truly awful experience with misbehaving contractors motivated under contracts paying
on a cost-plus-a-percentage-of cost basis, the reaction of our republic was to make it a
crime for a contracting office in the Defense Department to sign such a contract, and not
only a crime, but a felony.

Real Estate
I often see this practice in real estate property management business. Every time the
owner of the property incurs an expense, he gets billed for the cost-plus-a-percentage-
of cost. This scares me since the property management company is operating under the
influence of incentive caused bias. What is good for the company is not good for the
owner.

Do you remember the real estate crash of 2008. Why did the borrowers default on their
loans? Why did the bankers approve these loans? Most of these loans are subprime in
nature. Bankers were paid for the market share/volume of the loans and not based on
the net profits these loans generated. Hence the crash was inevitable.

Caesarian section(C-sections)
C-sections accounts for 9% of all births in India. Why? It is very simple. Caesarean
delivery costs an average of Rs 30,000 more than normal delivery. Some estimates say
C-sections have risen from 5% to almost 65% in some private hospitals in India. The
doctors are operating under the influence of incentive caused bias and hence they
prefer C-sections over normal delivery.

I often wonder how could there be a relationship between a retail investor and his stock
broker/financial advisor. The goal of the investor is to buy low cost financial products
like index funds, trade less often and there by paying less in transaction costs and
taxes. The goal of the stock broker is to maximize his returns by selling high cost
financial products and make you trade more as his commissions depends on the
volume. The goals are orthogonal. How is this relationship favorable for both?

The Anchoring Bias of Investors

Fixed on a specific price? It affects your investing.

When formulating a financial decision, prediction, or guess, you have to start

somewhere. The initial price or number you pick turns out to have enormous influence
on your final conclusion. That is, you anchor to this initial price and make adjustments
from there. These adjustments are frequently inadequate. Such biased results in
forecasts underweight new information and can thus give rise to predictable, and yet
surprising, forecast errors.
This anchoring bias impacts many financial decisions. For example, the awards from
lawsuits are influenced by the plaintiff's initial demandthe plaintiff gets more if he or
she requested more. In real estate, people are unconsciously influenced by arbitrary
posted prices. In online auctions, the prices bid are anchored by the non-binding "buy-
now price." And earnings forecasts by financial analysts are biased towards the
previous months' data as an anchor. Issuers of initial public offerings anchor to the
midpoint of the initially filed pricing range. This may cause them to become complacent
about assessing the new information gathered in the going public' process and thus
may contribute to the underpricing of IPOs.

A particularly strong anchor is the purchase price of a stock. You might have heard (or
said), "if the stock would just go up to what I paid for it, I'd sell it!" Not exactly a ringing
endorsement of the investment. Our assessment of the stock performance and how we
feel about it is determined by this buy-price anchor. This can lead to odd behaviors like
selling your winners too soon and holding on to your losers too long. This is called the
disposition effect (posting on this coming soon).
The Marshmallow Experiment at Stanford University
The idea was to study the traits of successful individuals or communities to understand
why they succeed. The experiment involved a group of children who were asked to sit
on chair. A treat was kept on a table before them. The treat could be a marshmallow, a
cookie, or a pretzel.

The kids were told that they are free to eat the treat but if they do not eat it for the next
15 minutes, they would get two treats. The instructor then left the room and studied their
behaviour from another room where the children could not see them.

A few children ate the treat as soon as the instructor left. A few others waited for a few
seconds but couldnt resist their urge to pounce on the treat. Some others
pounded on the treat as if venting their ire on it, and some others just turned around so
that they could not see the sweet. Finally, some children simply waited for 15 minutes
and were rewarded with two treats for their patience.

After about 15-20 years, these children had turned adults. The experimenters followed
up with the children. Of them, the ones who had delayed gratification tended to have
better results in their lives. They were, on average, more successful in their social and
professional lives, had better SAT scores, and body mass index.

Delayed gratification for investors

The relevance of this study hasnt been more important than in todays age of instant
gratification. If you study the greatest investors of our time, the only thing that connects
all of them is the patience to get better returns tomorrow than enjoying the little gain
today.

The soundbites on television, stock recommendations on sell and buy in newspapers,

SMS on day trading, etc. have made todays investors more confused. Everyone seems
to guarantee big returns in the shortest time possible. However, it is impossible to gain
large in the short term unless you have sheer luck riding with you.

Lets understand how delayed gratification could work for investors.

Step 1: Have An Objective

Planning begins with the realisation that youll meet some steep financial challenges
which need careful thinking. These challenges could be getting married, buying a
house, funding your kids education, buying a car, planning for retirement etc. None of
these events can be funded with the income you ordinarily generate. You need to have
a long term plan to raise the money and overcome your challenges. Once you know
what your challenges are, you start taking the steps that would help you overcome
them.
Step 2: Save & Invest

Wealth creation is the art of accumulating or creating value. Unless youre a Mark
Zuckerberg or Bill Gates who imagined and created multi-billion dollar corporations,
youre going to have to be very careful about how you save and invest your limited
income. So control your expenses, save as much as you can, and invest the largest part
of your savings. Differentiate between wants and needs, and resist the urge to splurge,
since splurging diverts you from your goals. Buy equity and mutual funds if you have the
risk appetite; or stay safe and lock up your money in deposits, bonds and certificates.
Diversify between all those options and reap the benefits from all of them.

Step 3: Remain Invested

This is where it starts getting tough. Its easy to get excited by short-term savings and
growth, and its very tempting to dip into your little pile of cash and enjoy spending it.
But dont do it. This money is your marshmallow. Dont eat it now, and enjoy doubling
(or quadrupling) it in due time. Delay gratification, and let your investments grow over
time. The longer you remain invested, the more you grow.

Step 4: Prepare For Contingencies

Dont let setbacks in your life damage the value of your investments. Always have an
emergency fund and insurance plans to meet short-term problems such as a job loss, a
medical emergency, accidents, damages, etc. This fund could be six to 12 months of
your monthly income. Also, get yourself and your dependents insured. Health insurance
could potentially save you lakhs of rupees during a hospitalisation which you would
have to raise by dipping into your investments or by borrowing.

Step 5: Reap Your Compounded Growth

If you had stuck to your investments and not cashed out, your net worth would have
grown significantly. For example, if you invest Rs. 10,000 in an SIP providing returning
10% annually for 10 years, you would have a corpus of Rs. 21 lakh. Stay invested in the
plan for another five years, and your investment doubles to Rs. 44 lakh. Go another five
years, and your corpus grows to Rs. 86 lakh. This is the power of compounded growth
growth upon growth.

The learning from the Marshmallow Experiment is clear. Investors, who can delay the
little gain they get today for a larger gain tomorrow, are the ones who actually make
money in the stock market.