Behavioral Biases-II

Bias-1
• Lottery experiment
• You toss a coin and if tails you loose 1000. how much do you want to gain on heads?
a) >1000
b) <1000
c) 1000
• You’re in the office and you overhear you boss saying he wants to give you a raise of
4000/month.
How happy would you be to find out about this unexpected gain?
• Now imagine a different situation.
You’re making a coffee when you hear your boss talking to HR manager about.. cutting
your salary down by 4000/month.
How would that make you feel? Sad? Angry? Even furious?
• Suppose you make a plan to invest $50,000. You are presented with
two alternatives. Which scenario would you rather have?
1. a. Be assured that I’ll get back my $50,000, at the very least—even
if I don’t make any more money.
2. Have a 50 percent chance of getting $70,000 and a 50 percent
chance of getting $35,000.
• Suppose you make a plan to invest $70,000. You are presented
with two alternatives. Which scenario would you rather have?
a. Know that I’ll only be repaid $60,000, for sure.
b. Take a 50-50 gamble, knowing that I’ll get back either $75,000 or
$50,000.
• Choose one of these two outcomes:
a. An assured gain of $475.
b. A 25 percent chance of gaining $2,000 and a 75 percent chance of
gaining nothing.
• Choose one of these two outcomes:
a. An assured loss of $725.
b. A 75 percent chance of losing $1,000 and a 25 percent chance of
losing nothing.
• I am happy getting 7% interest in fixed deposits rather than investing
in equity.
• I bought DLF at 600. Saw a high of 1300 and a low of 150. Today it is
350 and I am still holding it.
• I was lucky to participate in Tech boom. Made good profits in Infosys
and Wipro early. I hold Pentafour, DSQ and Visual. I could not sell
them as they went down after my purchase
• You have complimentary tickets to a live concert by Arijit Singh. On
the night of the show there is severe windstorm and rain and entire
traffic is disrupted by floods. Will you go to the concert?
• You have bought the tickets to the show by Arijit Singh for Rs.10000.
On the night of the show there is severe windstorm and rain and
entire traffic is disrupted by floods. Will you go to the concert?
• Eating a bad taste food just because you bought it especially when
you bought it from an expensive restraunt.
• Seeing a movie just because you have seen it half.
• Sunk Cost fallacy
Loss Aversion Bias
• People tend to strongly prefer avoiding losses than achieving gains.
• Pain of loss is 3 times more than the pleasure of an equal amount of
gain…. Loss Aversion.
• Myopic loss Aversion combination of mental accounting, framing and
loss aversion biases.,,, Not seeing one’s investment performance
Consequences
• Hold losers and sell winners
• Limit the upside potential.
• Trade more than usual due to selling winners.
• Hold riskier investments
Overcoming
• Analyzing investments fundamentally and realistically considering the
probabilities of future losses and gains.
• Consider yourself I a situation where you are not selling a losing stock
but may be one day one of your family member sells it and gives you
cash. Will you not be able to purchase profitable stocks with that
cash?
Bias-2
• Consider this: would you take a 13,000 wage increase to relocate to
another city? Most people would say no. Yet consider the opposite: If
you were living in another city, would you take a 13,000 wage
decrease to move back to this one?
• Status quo bias: conversation between Roopesh and Satish .
• Decision Paralysis: lose a house, opportunity to buy your favourite
stock, invest in a mutual fund
Reasons for decision paralysis
• Fear of going long
• Probability of making loss
• Desire to avoid looking foolish
• Unwillingness to take risks
• Egs: changing composition of inherited portfolio, new fund manager
taking charge of a fund
• Decision paralysis during IT boom, opening of mutual funds in private
sector along with UTI
Reasons for decision paralysis
• Buying top performing funds and sticking with them.
• Not selling junk stocks during rally.
• Your investment portfolio contains a certain high-quality corporate
bond. The bond has been providing income for you, and you are
happy with it. Your financial advisor analyzes your bond holdings and
recommends that you replace the corporate bond with a treasury
bond of comparable quality, estimating that you will obtain a better
return after capital gains taxes and fees. You aren’t familiar with this
treasury bond. What is your most likely response?
• a. I will sell the corporate and purchase the treasury bond.
• b. I will keep things as they are.
Status quo bias
• People do nothing.
• They are more comfortable in keeping the things same than with
change and do not look for opportunities where change is beneficial.
• Always select the default choice.
• CONSEQUENCES
• Unknowingly maintain portfolios with risk characteristics
inappropriate for their circumstances.
• Fail to explore other opportunities.
Detection and overcoming
• Education
• Quantify the risk reducing and risk enhancing advantages of
diversification and proper asset allocation.
Conversation between a broker and his client
Mr. Ganesh
• Mr. Ganesh: What is the price of Tata Steel?
• Broker: Sir: it is 298/299
• Mr. Ganesh: give me a call when it reaches 300. I need to sell.
• The price reaches 301
• Broker: Sir the price is Rs.301/302. should I sell? It is one rupee over
your limit price of Rs. 300.
• Mr. Ganesh: The market seems to be going up I will wait till a limit of
Rs.305. Give me a call once it reaches 306.
• The price goes upto 306 and the broker calls.
Conversation between a broker and his client
Mr. Ganesh
• Broker: The price is 306. What should I do? Should I sell?
• Mr. Ganesh: Keep a limit of 315. If it touches that don’t even ask me.
Just sell.
• The price goes down to 301 and the broker calls.
• Broker: The markets are down and stock has fallen to 301. What
should I do?
• Mr. Ganesh: The market may be down but this is a great stock. It will
rebound and we will sell it for Rs. 315
• Exchange experiment
Conversation between mother and her son
Raju.
• Assume that you purchased 100 shares of GE in a self directed account
and paid a commission on the transaction. Shortly following the
purchase, you realize that you momentarily overlooked another 100
shares of GE that you already owned in another account. Now, the
redundant holdings are causing an imbalance in your overall portfolio.
What is your reaction to this situation?
a. Since I paid a commission and I like GE’s stock, I will keep GE even
though it may cause an imbalance in my overall portfolio.
b. I am not comfortable with imbalance in my portfolio. I will sell GE, even
though this means that I will have paid two unnecessary commissions
Endowment effect
• People value an asset more when they hold rights to it than when
they do not.
• Difference between the price at which one is willing to buy and the
price at which one is willing to sell.
• Attitude towards the items held over a long period of time/inherited
items or may be immediately acquired items.
Consequences
• Fail to sell off certain assets and replace them with other assets.
• Mentally overvalue the stocks they hold
• Maintain inappropriate asset allocation
• Hold familiar asset classes.
• Become good salesman of the company’s stock which they are
holding.
• To overcome: try to replace small old purchases with new ones which
are unfamiliar.
• Don’t get married to your stocks
• Suppose I have to choose between a LG TV and a Sony TV
• Apparently similar quality, but I trust the reliability of the LG more, and am
willing to pay extra for that
• I buy the LG TV, and it breaks down shortly out of warranty
• I regret choosing LG
• I regret choosing to pay more money for the brand name
• Suppose I then have to buy a new mobile phone
• I have narrowed my choice to a cheaper LG, and a more expensive Apple
iPhone
• I previously chose the LG product, and regretted doing so
• Suppose that makes me less likely to choose an LG product again
• But, at the same time, I also spent more money on a supposedly
better brand, and regretted doing so
• Which now acts on the “supposedly better brand” iPhone
• In this example
• The context from the initial experience of regret appears again
• But acts in opposite directions on the decision maker
• Does one of these things matter more than another?
• It’s probably an impossible task to create a definitive list of
characteristics and context which matters for regret
• And the subsequent effect of experienced regret
• Can we approach it the other way?
• Are there characteristics of a decision which simply aren’t linked to
the experience of regret?
• Does the brand name “LG” matter?
• Given I don’t assume that the probability of my phone failing is linked to the probability
of my TV failing
• Suppose that you make an investment in Stock ABC and that over the next
12 months ABC appreciates by 10 percent. You contemplate selling ABC for
normal portfolio rebalancing purposes, but then come across an item in the
Wall Street Journal that sparks new optimism: Could ABC climb even higher?
Which answer describes your likeliest response, given ABC’s recent
performance and this new information?
a. I think I’ll hold off and sell later. I’d really kick myself if I sold now and ABC
continued to go up.
b. I’ll probably sell. But I’ll still kick myself if ABC appreciates later on.
C. I’ll probably sell the stock without any second thoughts—regardless of what
happens to ABC’s price after the transaction.
• Suppose that you’ve decided to acquire 200 shares of LMN Company. You purchase
100 shares now at $30 apiece and strategize to wait a few days before picking up the
additional 100. Further suppose that soon after your initial buy, the market takes a
comprehensive dip. LMN is now trading at $28, with no change in fundamentals.
• Which answer most closely matches your thought process in this situation?
a. I will probably wait until the stock begins to go back up before buying the remaining
100 shares. I really don’t want to see LMN fall below $28 because I’d regret my initial
decision to buy in.
b. I will probably buy the remaining 100 shares. If LMN ends up going below $28,
though, I will regret my decision.
c. I will probably buy the remaining 100 shares. Even if LMN falls below $28, I don’t
think I’ll experience a lot of regret.
• Suppose you have decided to invest $5,000 in the stock market. You have narrowed your choices down
to two companies: Big City Company, Inc, and Small Town Company, Inc. According to your calculations,
both stocks have equal risk and return payoffs. Big City is a well-followed, eminently established
company, whose shareholders include many large pension funds. Small Town has performed well but
has not garnered the same kind of public profile as Big City. It has few well-known investors. Which
answer most closely matches your thought process in this situation?
a. I will most likely invest in Big City Company because I feel safe taking the same course as so many
respected institutional investors. If Big City does decline in value, I know I won’t be the only one caught
by surprise—and with so many savvy professionals sharing my predicament, I could hardly blame myself
for excessively poor judgment.
b. I will most likely invest in Big City Company because if I invested in Small Town Company and my
investment failed, I would feel like a fool. Few well-known investors backed Small Town Company, and I
would really regret going against their informed consensus only to discover that I was dead wrong.
c. I would feel indifferent between the two investments, since both generated the same expected
parameters for risk and return.
Regret Aversion
• People tend to avoid making decisions out of fear that the decisions
may turn out poorly.
• Investors may hold on to positions too long and may be reluctant to
sell as they fear that the position may increase in value and they will
regret having sold it.
• They may remain out of market when thy have faced huge losses.
• Error of commission regret: Regret from having taken an action
• Error of omission regret: Regret from not having taken an action.
Consequences & overcoming
• Can initiate herding behavior as people may feel safer in popular
investments in order to limit regret.
• Be too conservative in our investment choices.
• Overcome: education
• Understanding that losses happen to everyone and keeping in mind
the long term benefits of including risky assets in portfolio