EVEN TRUE STORIES ARE FAIRYTALES -Story Bias

We work on interpret information as being part of a larger story or pattern, regardless of whether the facts support or not. We want our lives to form a pattern that we can easily follow. It is clear that people first used stories to explain the world before they began to think scientifically. Making mythology older than philosophy. This has led to the story bias.

Business – Good storytellers know that including specific details is essential to capturing the listener’s imagination and making a story believable. So that businessman uses this bias to build a story around the products/services which can easily attract huge customers. When any good story about any product getting circulated then people are more likely to listen, empathise and act.

Investment – We are getting attracted by stories and those stories getting sold everywhere. We get to know about the story of any company and that attracts us, we invest rather checking that does these stories has any truth or not? If it is true then also, does it make sense at the current level of the price? When there is a success of any company, we get many stories on it. So that when any rosy story comes to us, we should check it thoroughly without any biases in mind with searching for disconfirming evidence. I always quote that “Stories are for kids, not for investors.”

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

WHY ‘NO PAIN, NO GAIN’ SHOULD SET ALARM BELLS RINGING – The It’ll-Get-Worse-Before-It-Gets-Better Fallacy

We have heard No Pain No Gain concept everywhere but it is not always suitable for all situation. When we do a workout then we keep getting pain due to training of different muscles. But if we do a workout in a wrong posture then we get pain without gain for a lifetime.

When we go for so-called advisors then they do not have any knowledge of problem or solutions but also they suggest a solution for a particular problem. They also suggest that things can worsen before it will get better. Without the availability of proper solution, things will be going to worst and we believe that it has happened as an advisor has warned. And if things get better suddenly, advisors say that it’s because of my solution. So, both the side he will win.

Investment – I have met many people who used to predict market direction, they always quote that market seems dicey and can fall but also seems little chance to go up. So, either market fall or rise, the prediction proved right. We have to be careful while asking for a piece of advice. We should check the process, experience, knowledge first before the implementation of their bits of advice.

When any company making huge Capex then management tell us that we have to take short-term pain for getting better in a longer-term. It is true and management must have to take such a bet. But we have to check that does the company has the potential to grow in future? Does it have a strong balance sheet to take short-term pain? (If not then that short-term pain can become a disease for a lifetime.) So that we always have to make proper study before reaching to any of the conclusion. We have to develop a proper checklist which can tell us if we are missing any part to study or filter out a distraction from us.

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

WHY WE PREFER A WRONG MAP TO NO MAP AT ALL – Availability Bias

We create a picture of the world using the examples that most easily come to mind. This is absurd, of course, because in reality, things don’t happen more frequently just because we can conceive of them more easily.

Unusual events (such as botulism) attract disproportionate attention and are consequently perceived as less unusual than they are. The world in our heads is not a precise replica of reality; our expectations about the frequency of events are distorted by the prevalence and emotional intensity of the messages to which we are exposed.

Our views for the world get changed as per available information, media news, etc. We create an expectation about events based on messages which can be distorted and can be far from reality. Media also uses these as exaggerate the news to enhance our viewership.

We majority focus on what is easily available or happens frequently in front of us rather than what can happen rarely or difficult to think. We have fear of death by car, plane or other accident rather than due to medical conditions. Because we have seen and read about many death through an accident.

Availability of the information will alter our decision and act. For example, 9/11 attack or COVID-19 will temporarily create a negative impact on the mind of travelers.

Protective actions, whether by individuals or governments, are usually designed to be adequate to the worst disaster experienced. We as a human being never accept the worst scenario can come. We get anchors with ongoing good period and keep thinking that this will remain forever until a disaster happens.

We all know that we should take healthy food, focus on diet, workout but we did not focus on it until COVID-19 has arrived. So now, the majority of people think about health and diet but still, few who are like dog tail, continue with junk.

Business – “The CEO has had several successes in a row, so failure doesn’t come easily to his mind. The availability bias is making him overconfident.”

Businesses also just not focus on what happens frequently but what can happen. So that they have to prepare for worst-case scenario also.

Investment – We attracted to invest in the stocks, sector which having an easy availability of information and that will lead to the bubble into particular stock or sector. We tend to avoid stock or sector which does not have enough information available though that stock or sector can be good.

When we have received continuous success then we will not generally think of meeting failure. Similarly, with investment, when people getting good returns from their investment, they forget about the inherent risk of equity investment.

When we have performed something recently, then the availability of those experiences goes everywhere with us and that mould our decisions. For example, when we have watched all parts of Sherlock Holmes in a few days, then we have the effect of it on our mind which attracts us to think suspiciously.

Rather on belief in instances, we should focus on statistics which can help us to make a wise decision.

We never prepare ourselves for the worst disaster until it arrives. This is the worst risk management example. When the market keeps rising, we think it will keep going to the upward direction, never fall. This anchoring effect of recently available information ties us to avoid risk. And we focus on risk after it comes to us. We need to focus on what can happen rather than what information is thrown to us. We have to think optimistic as well as pessimistic scenario when investing with all statistics. So that we can make a wise decision.

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

LEAVE YOUR SUPERMODEL FRIENDS AT HOME – Contrast Effect

We judge something to be beautiful, expensive or large if we have something ugly, cheap or small in front of us. We have difficulty with absolute judgements. So that we always decide on a relative basis.

When a person goes for a marriage meeting and wants to get selected in meeting then he should go with a below normal-looking friend or need to go alone rather go with a handsome looking friend. When a person looks nice comparatively then he has a higher chance of getting selected.

We cannot see small changes over a period so that Contrast effect make us blind through small changes.

Business – A product that has been reduced price from $100 to $70 seems better value than a product that has always cost $70. The starting price should play no role. Majority of the businesses uses this technique to attract more customers and increases their business.

Another technique used by businesses to sell 2 different products where one has some lower feature than the later product but the later product has slightly higher in price than a first product which attracts customers to buy the later product.

Investment – Initial days of my career, I have to communicate my research works to the retail clients. So, when I recommend the idea to them, many of them ask immediately a question that what was a 52-week high and low. If a stock is near to 52 weeks high then they do not prefer to invest in it. But stock either near to 52 weeks low or substantially lower than 52 weeks high then they prefer to invest. Also, if peers stocks have posted good return then people run behind which stock do not have performed well.

We should focus on what is a potential of stock from a current point rather than where the stock stands from its  52-week high and low.

Many investors focus on relative valuation i.e.; the company is relatively cheaper than its peers then that company has more chance to give a return. This may be correct. But we need to check that does that company has potential to meet the valuation of peers. It also can be possible that the inherent problems of the company tend to deserve such a lower valuation. So that we need to study all the company in an absolute manner, prepare positive & negative points of it. then have to look at does it undervalue or overvalue rather just compare it with peers valuation for decision. Any company should get valued on its inherent merit and demerit.

Another point is that when we have diversified our portfolio to a great extend then little changes in it does not affect our portfolio and that investment slowly loses our attention. So that we need to keep portfolio size to the extent that we can give equal attention to each holding of the portfolio.   

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

DON’T BOW TO AUTHORITY – Authority Bias

Authority bias comes when we put an extreme trust on authority, expert of a particular field. We just follow what they say and do not doubt on their opinions.

Whenever you are about to make a decision, think about which authority figures might be exerting an influence on your reasoning. And when you encounter one in the flesh, do your best to challenge him or her.

Business – Corporate has authority bias as founder, CEOs, directors pass an order and everyone follows it. If someone has viewed with proper data, facts and logic then also cannot challenge their order.

Successful business houses have the practice to invite better ideas from different employees group or department so that they get better insights for improving efficiency and operation.

Investment – Comeback to the stock market, we follow many of the celebrated investors, fund managers and we consider them as an authority. We do not argue on their opinion, investments thesis. We also tend to follow what they are doing. This behaviour is very rapidly affecting the majority of the participants. If Mr XYZ has bought ABC stock then the majority of us do not think anything and just run to buy ABC.

We should work on the preparation of process & checklist from listening, reading each guru, books etc. The process should be on what suits our temperament. It may be possible that few aspects may not be accepted by our process what authority says then we should not to do. Evolve from this bias can help us with becoming an independent investor rather than being depending on the authority.

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

BEWARE THE ‘SPECIAL CASE’ – Confirmation Bias

The confirmation bias is the mother of all misconceptions. It is the tendency to interpret new information so that it becomes compatible with our existing theories, beliefs and convictions.

We have some initial thoughts, opinion on anything and we try to collect information, evidence which supports our initial thoughts. And kick out evidence which does not support our initial thoughts.

We inevitably land in communities of like-minded people, further reinforcing our convictions – and the confirmation bias. We generally like people who have similar interest as of us. So, this association will again influence our decision making. We should have people in our life who can show us the other side of the coin rather keep supporting our views. Our mind does not accept opposite views so that we have to make it habituate our mind to accept the opposite idea. 

Business – When any management makes any kind of capital allocation decision then they will start collecting information which is supporting their decision. But we should check that management get succeed who have a focus on both optimistic as well as a pessimistic result of their decision.

We have mainly seen such behaviour among the management of cyclical industries. When the business cycle starts improving, then management focuses on increasing higher capacity, disturbing balance sheet, etc. rather improve efficiency and strengthening balance sheet to be ready for an upcoming burst in the cycle. Good management focuses on increasing capacity when everyone avoids so that they can take benefits when the cycle turns to be profitable.

Investment – When we have invested in a particular company, we try to find out evidence which supports our investment, which tells us that we will gain from this investment. When we are fully invested with all our money, we work on identifying evidence which tells us that market will do well and we will earn good returns. Reversely, when we have a huge fund to get invested, we work on collecting evidence that tells us market will go down and we will get good investment opportunities. Rather falling in confirmation bias, we should try to collect positive as well as negative evidence with a neutral mind decide to continue with original thoughts or to modify or change it.

Many a time, I have seen that people get emotionally attached to their investment so that they do not want to hear anything against their investment. We have to understand that our decision does not prove to be correct every time.

We should write down our initial belief and work on collecting disconfirming evidence to our initial belief. When we have confirmed as well as disconfirming evidence then we can make wise & rational decision without getting biased. When we have invested in a particular company then we should prepare a sell report on the same company. And if we have not invested then should work on collecting evidence which tells us why we should invest at the current point of time.

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

DON’T ACCEPT FREE DRINKS – Reciprocity

Many NGOs, philanthropic institutions give us a gift and welcome us. After that when they feel that we have fallen under the softcore for them due to gift, they ask for the donation. Reciprocity is a very useful survival strategy, a form of risk management.

It is at the core of cooperation between people who are not related to each other and a necessary ingredient for economic growth and wealth creation. Reciprocity rule said that we try to repay what we get from someone. At last, we all are social animals. And when we give something to someone, we expect something in return. This is how our social life has been designed. This bias is so strong that by this, we can influence thinking and decision making of other people.

Business – This method is best used by marketing fellow who comes to us with some exciting advice free of cost and in return, we will buy what they are selling. When sales personnel put lots of efforts on us then we try to buy something from them. When any company keeps taking care of their customers such as sending wishes on their birthday, anniversary, sending gifts, etc. then those happy customers will buy services from that company on a repeated basis.

Investment – when we like the products or services of a particular company, we try to put our money into it. It is a good decision at some extend but without digging in detail putting money is an unwise decision.

Many a time, our advisors also get some benefits from the company or they like the products or services of the company so that they issue buy recommendations. Opposite of it that sometimes, any unsatisfied with the product or service of any company to any of our advisors then they might start advising to stay away from that company to put money.

We should not blindly follow anyone rather doing their homework. For overcoming this bias, we need to give us a time, we need to dig deeper on each aspect of the company. We need to write down a thesis which contains the opposite side of our decision. It’s difficult to kill your idea but its necessary.

One of the power generation and transmission business – very lower return to no return in the last 14 years

One of the telecom company of India- also low return in the last 14 years

Dialogue from Mr Salman Khan best suitable to this bias – Do me a favour, that doesn’t do me any favours. (Idea taken from SafalNiveshak)

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

WHY YOU SHOULD FORGET THE PAST – Sunk Cost Fallacy

For Humans, mental accounts are a form of narrow framing; they keep things under control and manageable by a finite mind.

The decision to invest additional resources in a losing account, though better investments are available. This is known as the sunk-cost fallacy, a costly mistake that is observed in decisions large and small.

Many financial institutions refinance bad loans with the hope of recovering them. If the company starts doing well through an additional loan then should give an additional loan rather than book it as an NPA. This will result in a larger bad loan on the book of institutions.

We have seen that loss-making business or division keeps getting funds from the bank or financial institutions. Also, many non-performing banks keep getting recapitalization from the government. This is an example of a fall of government into the sunk cost fallacy. We have seen in “Mahabharata” that King Yudhishthira keeps on gambling with the hope of winning everything back. He considered his brothers and wife as an available resource and played for winning back his lost fortune.

Investment – When we have invested in a few stocks and those turn out to be our mistakes but we resist booked losses from it. We think that if we book losses then it will occur but we do not think that loss already occurs, just we have not accepted it. A common practice by the majority of investors follow is to book winners and hold on with losers or average losers.

The sunk cost fallacy is most dangerous when we have invested a lot of time, money, energy, or love in something. We carry out with the burden of losses and invest more in it. As we invest more, we fall further into the trap of sunk cost fallacy and cannot take the exit with losses. This is irrational. I have seen many fund managers/research analysts who cannot reject ideas after they have made good efforts, though they found something wrong about their investment idea.

Overcoming a Sunk cost fallacy, we have to understand that the acquisition price has no role to play while making an investment decision. What counts is the stock’s future performance (and the future performance of alternative investments). So that if we feel that stock is more valuable and have the potential to perform well in the future based on its fundamental (not on basis of gut feelings) from current price then only we have to hold it or invest in it. We have to delete buy price column or have to ignore it. If we have found that business has some problem and will not grow it or will not sustain then we must have to take exit because holding that will defiantly going to give us a permanent loss of capital. 

We can see in the mentioned link that the public has increased their holdings in stocks which have eroded wealth.

QUALITY INVESTING CAN BE A CONTRARIAN INVESTING….

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

IF 50 MILLION PEOPLE SAY SOMETHING FOOLISH, IT IS STILL FOOLISH – Social Proof

We generally accept something as right when others are also performing it and we also start following the same. When one starts clapping at Drama show, all other starts clapping and join that fellow.

Social proof is the evil behind bubbles and stock market panic. It exists in fashion, management techniques, hobbies, religion and diets. It can paralyze whole cultures, such as when sects commit collective suicide.

It has been seen in students, they select particular stream as their career because their friends or others in their family has select it. They do not focus on what they like, whether that stream is suitable to them or not.

We have seen that when a few streams are in fashion; the majority of students chase that same stream rather focus on their skill or interest. We are a human animal so that human emotions affect our decisions.

Every time social proof does not create trouble. When we decide to go out for dinner and found 2 restaurant from which one has a crowd but other is vacant. Here, we should generally prefer a restaurant with a crowd. Herding becomes particularly useful in ambiguous situations because it simplifies the decision-making process. We should follow the crowd when the decision does not have a huge impact on our financial or in life.

Investment – When few start talking about buying a few equity investments than others also start following it and by seeing them succeed more will join their party. That will result in a bubble or burst.

We follow others without thinking about anything. When we see a few others are doing something then our mind stops giving us logical reasoning. I have met a few people before Covid-19 market panic. They were telling me that I should make the large investment as many mutual funds and PMSs have generated good returns in past. If you will not invest then you will miss out an opportunity. We should not follow what others doing rather should focus on their process. Equity investment has created wealth for people and beats inflation so everyone starts herd towards it without thinking about anything and any level. All the assets class has its merits-demerits so that we need to choose an assets class according to our temperaments rather chasing what others are doing.

Majority of the fund managers also follow social proof. If we see the various scheme of the same categories then the majority of the fund has a similar kind of portfolio. They focus on matching their benchmark return. We can see below portfolio of four different schemes of different AMCs, all those have many common stocks in their top-5 holdings.

For overcoming social proof bias, we need to create our circle of competence and investment process. We need to stick with it and let others do whatever they want to do. For example, if pure cyclical businesses do not fall under our circle of competence then we should avoid it though anyone has bought it. Also, the famous quote of Mr Buffett tells us a lot about overcoming social proof bias.

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

WHY YOU SEE SHAPES IN THE CLOUDS – Clustering Illusion

Many a time, people see the face of lord or shape of the lord, shape of a heart and so on in clouds. We hear many strange voices sometimes and feel that it wants to talk to us. The human brain seeks patterns and rules. It takes one step further: if it finds no familiar patterns, it simply invents some.

In the above images, we can see different faces in clouds. But actually, there is not any real face, our imagination creates faces in it.

Investment – In the market, we are getting overloaded with lots of data and many of us try to make patterns among those data. They use such pattern for trading into stocks. But that not work forever because we have created patterns where it has no existence.

When it comes to pattern recognition, we are oversensitive. We need to regain our scepticism. If you think you have discovered a pattern, first consider it a pure chance. If it seems too good to be true, find data which is tested mathematically and statistically. Never believe in any pattern if it is not supported with enough data over a long time.

Many investors believe that the company which choose buyback as a capital allocation plan then consider that company as a good capital allocator. But do we check rather a buyback is done below its intrinsic value or above its intrinsic value? What is the intension of the company behind buyback? Does the company want to hide previously diluted equity capital through buyback? So, we need to be sceptical before considering something as it similar as we saw it.

SIMPLE IS BETTER – ISSUE -13 – BUYBACK

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.