Beruflich Dokumente
Kultur Dokumente
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
Copy,
All I want to Paste,
know is where Emulate
I’m Going to Extreme
Extreme Mediocrity
Die So I never Failure Success
Go There
Ignore
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 what’s easily
available to it.
“When I’m not near
the girl I love, I love
the girl I’m near.”
The brain can’t
use what it
can’t
remember...
...or what it is
blocked from
recognizing
under the
influence of
certain
psychological
tendencies
The result? Mind tends to over-
weigh what’s 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 over-
weighing most available information?
Key Word:
Vivid
We under-weigh
rich and
concrete data
because it does
not evoke vivid
images.
Physicians response to
Surgeon General’s report
linking cancer to smoking
The probability that
a physician will
continue to smoke
is directly related
to the distance of
the physician’s
specialty from the
lungs!
What does
vividness do to
People’s Perception
of Risk?
We over-react to recent events
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
company’s 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...
“That’s 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 that’s
still going to
be lousy...
“The money still won’t 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 you’ll
save at
current prices
with the new
technology...
“However, they
don’t 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…
“I’ve 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 you’ve earned a return of
only about four percent per annum.
That’s the textile business...
“And it isn’t that
the machines
weren’t better.
It’s just that the
savings didn’t go
to you...
“The cost reductions
came through all
right. But the
benefit of the cost
reductions didn’t go
to the guy who
bought the
equipment...
“It’s such a simple idea. It’s so
basic. And yet it’s 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.”
Overreaction
Noise
to what you
see
Quantity not
as important
as quality
Information
Overload =
Noise
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
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
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 can’t afford to write this
off.
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 bank’s [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
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 price-
earnings ratios on exotic-
sounding 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 investor-
dreamers, 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
Consequence:
Excessive
Overreaction
“Available” worst case-
scenarios results in ignorance
of frequency and overweighing
of magnitude.
Consequence:
Utter Neglect
e.g. Terrorism vs
Climate Change
“It hasn’t
happened for a
long time, so it
won’t happen”
Earthquake and
volcano
eruptions
LTCM
“In all my
experience,
I’ve 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
1. Highest
bidder wins
2. 2nd
Text
highest
bidder also
has to pay
his bid price
to the
auctioneer.
HUH?
Deprival Super
Reaction Syndrome
(DSRS)
If you deprive
me, I’ll have a
super reaction!
“The quantity of a man’s 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?
Why?
Fear of losing our MTM
profits makes us sell out of
good decisions too early.
Lotteries
You don’t 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...
Darwin’s 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.
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