As market participants, we constantly seek to make decisions which we think are in our best interests so as to maximise returns. However in reality, there are many instances where we will be affected by our emotions and tend to act in certain ways which deviate from sound judgments causing us to behave in irrational manners. That said, behavioral finance is a relatively new field of study which combine cognitive psychological theory with conventional economics and seek to provide explanations as to why investors behave in a certain way.
Today, we discuss three interesting psychological pitfalls to take note of and hopefully give our readers an advantageous edge when it comes to making sound financial decisions.
Mental Accounting – “this $10 is not the same as that $10”
Suppose that you went for a movie on a sunny afternoon. And while queuing to enter the screening hall, you realised that you lost the movie ticket which you had already paid $10 for. Would you be willing to fork out an additional $10 to pay for another movie ticket?
Now assume that instead of losing the movie ticket, you realised that you had lost a $10 note on your way there. Would you be willing to come out with another $10 to purchase a movie ticket?
Surveys revealed that only 46 percent of the interviewees are willing to buy a replacement ticket for the lost ticket, whereas 88 percent expressed willingness to purchase a movie ticket after they had lost the $10 note even though they were disappointed. Buy why the difference? In both scenarios, the cost is the same at $10.
Mental accounting, a concept first established by economist Richard Thaler, purported that individuals tend to assign multiple mental accounts for the same resources, thereby affecting their decisions as to how these identical resources may be consumed. In the above example, losing a movie ticket and having to buy another movie ticket means having to charge a total of $20 to an individual’s “entertainment account”, which is considered too expensive for a movie. On the other hand, losing a $10 cash is not going to be charged to his “entertainment account”, and that is the reason why coming out with another $10 for a movie ticket has become a less painful scenario to bear.
Mental account also explains why some speculators tend to be willing to take on more risk when they are already having a paper gain, feeling that they are now playing with the “house” money rather than risking their “own” money. Nonetheless, a profit is still a profit regardless of whether it is a paper profit or a realised profit. The unrealised profit on the table should still be assessed with the same risk-reward analysis the speculator would have done as if it was his own capital, as any money lost is very much his own money too.
Fairness Fallacy – “It ain’t fair!”
Let’s say somebody offers you a $100 cash to be split between you and your partner, and both parties get to keep their share if a mutual agreement on the proportion could be reached. How would you propose? How about a $90-$10 split? Will your partner accept your proposal? Why not? Nobody in the right mind is going to reject a free $10, right? Yes, he will. Chances are, anything less than a $70-$30 split is going to be faced with some strong resentment. Why? Simply because, it ain’t fair!
You may be surprised that the same traits have been exhibited by our primitive relatives too. There was this experiment done with two capuchin monkeys in which they were trained to exchange a granite stone for a cucumber slice, and they will cooperate 95 percent of the times. But if one monkey got to receive a grape instead (which monkeys prefer over cucumber slice), the other monkey will only cooperate 60 percent of the time. And if the first monkey may receive a grape without even required to swap a granite stone for it, the second monkey will only cooperate 20 percent of the time. On a side note, there are instances when the second monkey became so unhappy about the inequality that he started throwing the cucumber slices back at the researchers.
The fairness fallacy is a mistaken belief in which it is assumed that all actions will always yield a result that is morally justified. But if you could just sit down and think about it, life has never been anywhere close to being fair. Investment guru became a billionaire through value investing, could you have done the same by applying his techniques? And when you saw you neighbor next door achieving a 20 percent return on investment buying a certain stock, you did the same hoping to get the same result. Well, think again. Life isn’t always fair, and things will not always work out in your favor even when you think they should.
Relativity Bias – “50% Discount Seems Like A Better Bargain”
Studies revealed that people are more likely to make an effort travelling down town to buy a $100 phone marked down by 50 percent sale, than to purchase a $1,000 plasma TV having a $50 discount. This seems rather illogical. A $50 saved is still a $50 saved, no matter if you saved it from a 50 percent discount deal or a five percent off transaction.
Here’s another example. Suppose you can earn a monthly salary of $2,000 in Town A where everyone else around you are taking an income of $1,000, whereas in Town B you can only fetch a salary of $4,000 where everybody were getting $8,000 a month. And the cost of living and quality of life in both towns are comparable. Which scenario would you rather be in? Most people would prefer to live in Town A. But why? If the expenses were the same in both towns, shouldn’t the higher income which you may get in Town B bring you a more comfortable lifestyle?
Apparently relativity bias is working its magic here. The human mind has a natural inclination to form conclusions or determine value based on relative references, when in reality it may be irrational and not making any economic sense. In the first example, we unconsciously judged the value of the savings relative to the absolute amount that we are going to spend. Likewise, the second example demonstrated that most people would instinctively choose to evaluate worthiness in comparison instead of looking at it in absolute terms.
In the stock market, many a time we will deem a stock that had plunged 50 percent to be relatively more undervalued as compared to another counter which corrected 20 percent when in fact, this may not necessarily be the case. When a stock fell sharply in price, more often than not there should be a reason accountable for that fall. Now that we have understood the relativity bias better, perhaps we should not be too quick to judge but to allow ourselves more time to look at the whole picture in a more objective and complete manner.