Category Archives: Behavioural Finance
Framing Effect – how options are presented
Framing effect is an example of cognitive bias, in which people react differently to a particular choice depending on whether it is presented as a loss or as a gain. People tend to avoid risk when a positive frame is presented but seek risks when a negative frame is presented. Gain and loss are defined in the scenario as descriptions of outcomes (e.g. lives lost or saved, disease patients treated and not treated, lives saved and lost during accidents, etc.).
This is basically how you put the options or ask questions to a person or a group of people. You can derive the expected answer by framing the options or questions in such a way that most of them will choose the option or answer that you expect them to choose.
A research shows that a car accident video was shown to two sets of people. The first set was asked to guess the speed of the cars before they went into ‘contact’. The other group was asked to guess the speed of the cars before ‘collision’. Because of the words chosen, the second group guessed the speed of the cars to be a lot more than the speed mentioned by the first group. Also, when asked whether they noticed the smashed glass in the accident scene, the second group told that they found smashed glasses in the scene. But, there were no shattered glasses in the scene at all.
Framing Effect examples
1. Which one is heavier – a pound of sand or a pound of cotton buds? – Surprisingly, few times I have personally seen people instantly say ‘a pound of sand’. Try this out with your friends.
2. Which pack of chips is good for health? – 80% lean or 20% fat? – Looks like most people chose 80% lean, though both packs have same amount of fat.
3. We have watched in movies that in a courtroom scene, procedures do not allow lawyers to “lead” a witness when asking questions, in order to prevent the witness to fall prey to the framing effect.
4. Using the term ‘global warming’ causes a higher impact than the term ‘climate change’
5. Several instances of mis-selling of financial products like insurance policies, Ulips, teaser loans, 0% interest on retail products purchase loans etc.,
Overcoming Framing Effect
1. Properly analyse and calculate all the possibilities before making a decision
2. Like Charlie Munger referred, ‘Invert’, ‘Always Invert’ – Ask questions from all dimensions and even stand on the other side of the table and look at the options
3. If anything is too good to be true, take the cautions side and delay the decision
4. Learn probability and calculate the % of success and failure, before betting anything big.
My experience with Framing Effect
My early day insurance policies were Money Back or Endowment policies. My insurance agent explained all the types of policies his company had on offer, and clearly insisted on me buying these types of policies because I will get ‘the premium + bonus’ back after certain number of years. He also highlighted that I ‘will not get any money from the company’ if I choose the term plans. Neither he explained, nor did I analyse all the aspects of all types of policies.
Net net, he framed the options in such a way that
– option 1 = pay premium, and get it back with bonus at the end of policy term
– option 2 = pay lower premium, and lose all of it at the end of policy term
So, now you know which option I had chosen. 🙂
Of course, after I started learning personal finance and investing, the first few things I did was to surrender all the above types of policies, and chose only one term plan.
Mere-exposure effect – Familiarity effect
The mere-exposure effect is a psychological phenomenon by which people tend to develop a preference for things merely because they are familiar with them. In social psychology, this effect is sometimes called the familiarity principle.
This is a tendency for individuals to prefer an option that they have exposed to already or heard of or known already than a totally strange one. This is also to avoid taking unnecessary risks by choosing an option or trying an option that is totally new.
Though there is nothing wrong in making choices with this effect, and it may also help us avoid losses, just because we choose a familiar one, it need not necessarily be the best choice.
Mere-exposure effect examples
1. You would have met someone and you might not have liked him/her much. But, as you continue meeting them or working with them you may start to like them and feel comfortable.
2. We may not like a song when we hear once or twice, but, if the same is repeatedly heard, we start liking it
3. We may not like an advertisement at the first shot, but, by viewing it again and again, we start liking.
4. Buying a particular brand of item – just because we are familiar to it either through advertisements, or we used already few times, or we know our friends and relatives use them.
5. Most of us may not want to try something new on the menu in the restaurant, and hence stick the ones we are already familiar with.
6. Given a situation when we have to trust someone, we prefer to choose someone who we might have already met once, even if we don’t know what they do or where they live, etc., rather than choosing someone who we never met.
7. Most of the population in India stick to insurance products from LIC, buy footwear from Bata, etc.,
Overcoming Mere-exposure effect
1. Making decisions based on facts and figures and proper analysis.
2. Discussing with the right experts on the particular area will help make the right choice.
My experience with Mere-exposure effect
During my earlier days of investing, I always used to buy stocks of familiar names and companies.
I bought stocks of Banks (SBI and HDFC), Auto (Tata Motors and Hero), FMCG (HUL and ITC), Oil & Gas (IOCL and Reliance), Technology (Infosys and TCS). Though these are great brand and fundamentally strong companies, I was able to make smaller profits because I forgot the aspect of margin of safety and hence was buying when their valuations were at their peaks.
False Consensus Bias – On the same page with me?
In psychology, the false-consensus effect or false-consensus bias is a cognitive bias whereby a person tends to overestimate how many people agree with him or her. There is a tendency for people to assume that their own opinions, beliefs, preferences, values and habits are ‘normal’ and that others also think the same way that they do. This cognitive bias tends to lead to the perception of a consensus that does not exist, a ‘false consensus’. This false consensus is significant because it increases self-esteem. The need to be “normal” and fit in with other people is underlined by a desire to conform and be liked by others in a social environment.
This is basically our assumption and overestimation on how others agree with our views and beliefs.
This could be because we naturally get along with friends and others who share our views and opinions, and hence we assume that in all aspects they will agree with our views and beliefs.
This leads to predicting that others too will behave like us in a given situation and making decisions.
False Consensus Bias examples
1. In workplace we may have a good performer, but, he/she may overestimate their skills and get to believe that all others in the organization also agree to them and behave accordingly.
2. In a love relationship, people think they are a right match and in a given situation they expect each other to behave the same way and also share similar views.
3. You watch a movie with your friends and after the show is over, you say that it was a horrible movie and why you thought so etc., but, one or more of your friends may say the movie was great and why he thinks so etc.,
4. When you go out for a purchase, your friend calls you and asks for a chocolate bar for him. You will buy the one that you like the most – assuming that your friends will also like it.
5. You believe that most people in this world want to save the environment, because you want it that way.
6. Even in an official meeting room discussion, when you raise some points, you may be surprised or taken aback but several people talking against your views
7. When a company fixes a price for a product launch, an employee may feel that price is too high – because he/she feels that is a high price – but, may not be for the market.
8. We watch few advertisements on TV which we may not understand for the first few times, that is because the advertising company thought all audiences will understand it because they understood it.
Overcoming False Consensus Bias
1. Being cautious when looking for consensus with others
2. Never jump into conclusions about what others think or believe.
3. Try to understand with others – either by talking to them or getting information on how they think before you make your decision
My experience with False Consensus Bias
During the 2008-09 market melt-down, when the stocks started falling off the cliff in early 2008, I thought the market has provided an opportunity to buy, and I assumed everyone would feel the same and go on a buying spree, which would pull up the market.
Based on this assumption I started buying heaving in early 2008, but, I was wrong because the market was trying to find is way down more and started falling further. I was trying to catch a falling knife assuming that others will also think the same way.
Disaster Myopia – History repeats?
The disaster myopia hypothesis is a theoretical argument that may explain why crises are a recurrent event. Under very optimistic circumstances, investors disregard any relevant information concerning the increasing degree of risk. Agents’ propensity to underestimate the probability of adverse outcomes from the distant past increases the longer the period since that event occurred and at some point the subjective probability attached to this event reaches zero. This risky behaviour may contribute to the formation of a bubble that bursts into a crisis.
This is basically the tendency of humans to forget the past disasters once they are long gone.
The tendency of people to greatly underestimate the chance of catastrophic events.
We tend to forget the past disasters after a long time which leads us to make decisions that lead to newer disasters.
Disaster Myopia examples
1. Any natural disaster when it occurs the authorities get on high alert and does all that is necessary to save people and assets. People plan and take all necessary precautions related to the threat to survive one such disaster in future. Once the disaster fades off from everyone’s memory and long gone people are again laid back.
2. Once a disaster strikes people start taking all types of related insurances and after years pass by, the insurance policies may not get renewed or more people may not take new insurances.
3. When we drive on a highway and notice a drastic accident, we go in high alert mode and start driving slowly for next few days or even months. After a year or so, our old driving habits come back.
4. If you are a smoker, and you hear some of your close friend gets cancer because of smoking, you will reduce the number of smokes a day or even quit for a few weeks, then after few months, you may start smoking again
5. All Financial bubbles and crises are formed, ballooned and burst because of this. All past history of financial bubbles like Tulip mania, South Sea crisis, 1929 crisis etc., were forgotten and hence we landed up in 2008 financial fiasco. This time it is different?
6. A person who is not satisfied with his job might quit before getting another job, and have had a tough time finding another job. He/She may repeat this even in future once the past tough times fades out – or may be thinking this time it is different?
Overcoming Disaster Myopia
1. Remembering the history of events is the most effective way before making key decisions in life
2. Making cautious and rational decisions can be brought in as a way of living and making decisions
3. In financial products, proper analysis, understanding biases, and purchasing with margin of safety
4. Discussing with your well-wishers before making key decisions will also help
My experience with Disaster Myopia
Even after reading and knowing my friends who lost heavily during the Tech bubble in 2000-01, I invested heavily during 2006-07 in infrastructure stocks. Starting Jan 2008, everything seems to break loose and started falling. Hence, I had to cut my losses earlier and get out with around 40% loss on few stocks. I think I was fortunate enough because those stocks went down further.
The denomination effect is a theoretical form of cognitive bias relating to currency, whereby people are less likely to spend larger bills than their equivalent value in smaller bills. It was proposed by Priya Raghubir and Joydeep Srivastava in their 2009 paper “Denomination Effect”.
In an experiment conducted by Raghubir and Srivastava, university students were given a dollar, either in quarters or as a single dollar bill. The students were then given the option to either save the money they had been given or to spend it on candy. Consistent with the theory, the students given the quarters were more likely to spend the money they were given.
It is basically a tendency to spend lower denominated money easily and quickly without any hesitation or negative feel, than spending higher denominated money.
That is, we may find it easier to spend five Rs.10 notes, rather than take a Rs.50 note to spend.
Denomination Effect examples
1. Spending coins than higher denomination notes. We always want to keep Rs.100 or Rs.500 in our wallet and spend lower denominations first. We have heard people say, ‘if I exchange it, I will spend soon’.
2. A product that is priced Rs.49.99 and Rs.49.00 and Rs.50.00 does not seem to have any difference
3. When we get a tax return or bonus as Rs.25245.00 – we tend to spend Rs.245 and save Rs.25000
4. Thinking if the price is lower, the product may be cheaper – yes, it could be, but, is it value for money?
Overcoming Denomination Effect
1. Trying to be rational with money is the basic thing to practice
2. Look at the real value of the money however small it is
3. Remembering what our parents taught us – several drops together make a stream – Smaller denominations make one large denomination
My experience with Denomination Effect
During my early days of investing, I have considered stocks which are in two digits are cheaper and especially if it is associated with a brand name, I bought them without much deeper analysis. I preferred to buy 100 shares of Rs.15 rather than buying one Rs.1500 share.
As I learnt investing and stocks and valuations, I understood that the price does not signify anything, instead only the value underneath the business is.
In decision theory and economics, ambiguity aversion (also known as uncertainty aversion) describes an attitude of preference for known risks over unknown risks. People would rather choose an option with fewer unknown elements than with many unknown elements. It is demonstrated in the Ellsberg paradox (i.e. that people prefer to bet on an urn with 50 red and 50 blue balls, than in one with 100 total balls but where the number of blue or red balls is unknown). There are a number of choices involving uncertainty and normally they can be classified in two categories: risky and ambiguous events. Risky events have a certain probability for a given outcome. Ambiguous events have a much greater degree of uncertainty.
This refers to our behaviour as humans where we prefer to choose risk taking against uncertainty.
Because, if there is a risk, we can work out the probabilities of those risks, severity of those risks, mitigation plans in order to avoid risk from happening, possible outcomes if the risk occurs, and what are all the possible steps to take if it occurs.
So, it is also basically, the easier route that we take to make a decision. We mostly choose to take simple and easy decisions, rather than logical and smart.
Ambiguity Aversion examples
1. We know as soon as we take any good out of a showroom, its value drops as it becomes second sale. This is a risk as we know, but, how much value will drop is ambiguous. We need to collect a lot of data to find that out
2. When we are given a tough situation to choose an option, we prefer to look for prior examples, as what others have done in similar situation and would prefer to go by that
3. In TV shows, where the person who has won a certain amount is usually given a choice to choose to either exit from the show with the current price money, or continue to play and risk losing half of it or gain more in further rounds
4. What speculators do in stock markets is in my opinion making decisions in ambiguous situations and what investors do is risk taking based on their analysis of the business, and they may also use probability theories to assess the risk and accordingly shell out only a certain amount in a stock.
5. Insurance companies will always look for the word ‘risk’ when they underwrite any policy. They never even think of an ambiguous situation as they never cover those
6. Predicting the future price of a stock has an element of risk, but, we have data to analyse and research to bring down that risk substantially, but, predicting the future macro-economic scenario is ambiguous.
Overcoming Ambiguity Aversion
1. There is nothing in specific to do about this – other than trying to be rational and subjective in decision making based on facts and figures.
2. Check if the situation is risky or ambiguous – If risky, then you have a chance to work out something and come out successful. If ambiguous, try to avoid it, else if you have to make a decision, try to convert the ambiguous choice to at least a riskier choice, so that you have data points to make decisions.
My experience with Ambiguity Aversion
During 2008-09, I had invested in several stocks with proper analysis, or as much as I could, which covered the risk part better, but, I was counting on the future economic growth and GDP rates projected, which I did not realise was ambiguous. Hence, few bets I made in infrastructure sector went bad, and I had to exit them at a loss.