Mental Accounting in Stock market

Hello friends, in today’s article, we see mental accounting in the stock market from chapter 7 of the book stocks to riches by Parag Parikh. In this, we understand, how we lose lots of money, by mental accounting error. This bias helps you to understand behavioral finance and get the idea of saving money and investing also.

so let’s start

Previous Chapter 6

Mental Accounting:- Stock to riches Chapter 7

Mental Accounting in the stock market

In this, the author (Parag Parikh) gives us some instances ( examples ) to show how mental accounting works,

so starts

Example 1

Dilip has just taken an MBA in finance. He was intelligent and had a sixth sense when it came to picking stocks. He worked for a brokerage firm and was respected for his ability to read the markets.

After a couple of years, he married Sonia. At that point in time, he had around Rs. 2 lakhs in his bank account. the year was 1991 when the process of liberalization had begun and the stock market was just taking off.

Being adventurous, Dilip decided to use his savings to trade in stocks. It was a wise decision considering his track record as a stock picker and his past success with the brokering firm’s clients. In the first year, his capital increased to Rs. 8 lakhs.

In 1993, his capital rose to Rs. 14 lakhs. two years later, confident in his success, he quit his job to become a full-time trader.

Sonia did not agree with this decision but he told her this would give him more time to develop his skills by attending various seminars and keeping up with his reading which was so very important.

he continued to do well and in 1994, his capital increased to Rs. 30 lakhs. the couple went on a trip to London. Sonia was very happy as they had moved to their own one-bedroom apartment.

In 1995, his capital soared to over Rs. 60 lakhs and so did his confidence. Being conservative, Sonia preferred to play safe. She insisted that Dilip should put aside some money in different safe assets, which they could fall back on in times of need. She was against Dilip investing all their capital in the stock markets.

Dilip did not heed her advice. He thought the higher the investment the greater the profit. Their different approach to money created a rift between them.

Arguments followed and the relationship was strained. Dilip’s winning streak ended and he began to lose. But he thought that since he had a comfortable balance there was no need to worry.

he betted heavily in a market that was going down and by 1997 he had lost everything. His flat was mortgaged to a financer, and Sonia filed for Divorce.

She accused him of being a compulsive gambler who lacked the financial prudence to take care of his wife. She said he could not handle money and had lost Rs. 60 lakhs in just two years in spite of her warning to save for their future.

Dilip was shocked. he had only lost Rs. 2 lakhs and that also over a period of six years.

so while reading this example, we don’t know about mental accounting, so for this author to give the explanation, just wait for more two examples, then we get the three examples and their explanation.

Example 2

Sunil and John were good friends. they worked for the same company and were financially sound. they enjoyed the good life and decided that every Saturday they would dine at a five-star restaurant. Each would pay the bill every alternate week. The first Saturday they dined at the Taj and Sunil paid the bill of Rs. 3000 with his credit card. the next Saturday they dined at the Hilton and this time john paid the bill of Rs. 2800 in cash as he did not have a credit card. the following Saturday the bill was Rs. 4200 and Sunil paid with his credit card. Next when john was due to pay, once again he paid the bill of Rs. 3900 in cash. After a couple of more such Saturday bashes, John told Sunil that they should quit going to five-star restaurants as it was very expensive. Sunil disagreed. He felt they needed this recreation and that they could afford it. He insisted they carry on and John gave in much against his wishes. The next time Sunil had to pay the bill he forgot his credit card and paid cash. the following day he told john that he agreed with him about staying away from five-start hotels.

These examples also do not give direct thought to mental accounting,

let’s see example three

Example 3

Bomsi was a spectator at a cricket match. He had with him a bag in which he had carried his provisions for the day. During the game, he was seen talking loudly and frequently on his mobile phones of which he had three. Suddenly, in the midst of an interesting over, he was heard arguing with an ice cream vendor. the dispute was over price. Bomsi showed the vendor this bag and told him, ” I have bought everything from home, even water. The only thing I can’t bring is the ice cream because it melts. But I will not allow you to cheat me.”

Now Bomsi was a cricket aficionado. he cheered both teams enthusiastically. After the lunch break, a player completed a century and Bomsi was ecstatic. he called the ice cream vendor, grabbed his bag, and generously distributed ice creams all around.

Within the next three hours, he did this twice more. After the game ended he settled his bill with the vendor and even gave him a hefty tip. this man who had fought over the price of ice cream in the morning had distributed ice creams by the dozens to people he did not even know. When asked about what he had done, he replied, ” I love cricket and I love to gamble on the game. When I win I like to celebrate. all my bets paid off. It’s the bookies who are now paying for the ice creams, so let the people enjoy.”

after this example, the author gives the idea of mental accounting

the author says, ” Mental accounting is an idea developed and championed by Richard thaler It underlines one of the most common and costly mistakes people make when dealing with money. it’s the tendency to place different values on the same sum of money depending on how it has been acquired and the effort required to acquire it.

Traditional economic theory assumes that money is fungible, meaning that one type of monetary unit can replace another. this means that Rs. 100 in lottery winnings, Rs. 100 in salary and an Rs. 100 tax refunds should have the same meaning as they have the same purchasing power. but studies indicate this is not so with individuals. People mentally separate their money in different accounts, giving each account a different significance.”

The three examples mentioned earlier

demonstrate how mental accounting affects people’s behavior, the author explains

the author says, ” Going back to example one Dilip started with Rs. 2 lakh and now has nothing. to him, his loss is only Rs. 2 lakh because his gains in the stock markets were merely his winning from his original capital and so not his own money. He treated the two accounts separately Sonia, however, does not suffer from this bias.

In example 2, every time john paid the bill with hard cash he felt the pain of seeing money go out of his pocket. Sunil did not experience this pain when he used his credit card. But When he paid in cash he understand the pain of parting with the money. and his attitude changed. In our minds, we distinguish between cash accounting and credit card accounting. Actually, both are the same, but we view them differently because of our mental extravagant when we use a credit card.

In example 3, Bomsi was stingy with his own money. But when he won, he become very extravagant. to him, his winnings were not his own money but that of the bookies. Hence the celebration mentally, he accounted separately for his own money and for his winnings. Let’s see what you would do in the following two situations.”

After this, the author gives the two situations to understand the mental accounting regarding money.\

Situation A:- You have paid Rs. 500 for a movie ticket. When you reach the theatre. you find that you have lost the ticket! Would you buy a new ticket? or would you prefer to go back?

Thinks about this, and keep your answer in mind.

Situation B:- You go to the theatre to watch a movie. when you reach the ticket window you find that you have lost Rs. 500 out of the Rs. 2000 you were carrying. would you still buy the ticket?

now think about this also and give the answer to yourself.

and check is right or wrong from the author’s explanation.

the author says, ” Most people would say no to the first situation and yes to the second.

However, both entail a loss of Rs. 500 and the cost of Rs.1000 to watch the movie. So why take different decisions? Because most people segregate the loss of the ticket and the loss of cash into independent categories or accounts and therefore react contrarily to the two situations.

Mental accounting is directly correlated to our emotional state. to understand it better, let’s consider different types of mental accounts and the human behavior associated with them.”

So for better understanding, the author gives us real-life experience and how mental accounting is work.

Earned Income V/s gift Income:-Mental Accounting in Stock market

in this, the author says, When we receive our salary cheque we are careful how we spend it. For we that money is sacrosanct, the fruit of our hard work.

But if we got a gift of the same amount of money you would treat it very differently we may spend it lavishly.

Mentally, to us, this is free money, but our salary money is not what we earned it, hence mentally we put it into a different account.

So this type of mental accounting has so many times happened to me. I know you also face this type of mental situation.

let’s now talk about other experiences.

Quantity of the money in Question:-Mental Accounting in Stock market

In this, the author says, ” we create mental accounts according to the quantity of the money and treat them differently. A tax refund is a tax-deferred payment by the tax authorities.

But when we get a tax refund of say Rs. 1000 we are likely to spend that without giving it due thought. However, a tax refund of Rs. 2000 will set us thinking, whether to deposit it in a bank or buy mutual funds and stocks, we do this because Small amounts go into important decision accounts.”

so this type of mental thinking really happens in our life, so now we know that then from now we know this, then think before spend and remember this mental accounting.

let’s take another example in real life

Large Purchases V/s Small Purchases:-

In this, the author says, ” When you want to buy a fridge you make a lot of inquiries before making the purchase you check out models and prices and even brands when you have found the one you like you to do some hard bargaining and maybe get a discount of Rs. 500 on a fridge costing Rs. 20,000. That makes you happy, but do you do the same when shopping for groceries do you realize that if you put in a little effort and are able to save Rs. 10 a day, at the end of the year, it would add up to a savings of Rs. 35000? Compare this with the saving of Rs. 500 on an expense that may not recur for the next 10 years or so.

Many people are cost-conscious when making large financial decisions, but they relax their discipline when it comes to small purchases. but that’s where the difference matters.”

These things also happen with us.

let’s see about credit card and cash example

Cash V/s Credit Cards:-

In this, the author says, ” Today credit cards are a status symbol. Everyone wants one, and every book is aggressively marketing it. It is a big profit earner for the bank and a hole in the pocket for the user who is not aware of the harm it can cause remember the example of Sunil and John

Sunil realized the value of money only when he paid the bill in cash. Because we have different mental accounts, we treat cash and credit card transactions differently. People tend to shop more. If they use credit cards as against paying cash. Actually, both represent your own money. It’s just that credit cards make us extravagant since we don’t see the money change hands. Moreover, we pay interest on the credit offered it is for this reason that credit card companies do a flourishing business.”

lastly, the author gives the Sacred money examples

Sacred Montey:-

in this, the author says, ” Ramesh was a successful investor and had done reasonably well for himself. One day he inherited Rs. 10 lakhs from his uncle. The uncle had worked hard and saved his money all his life. He did not take any risks and looked after this money with care.

Ramesh treated this money as sacred as he had received it from someone. who had toiled all his life to earn it? He would not consider putting it into the stock market where he had done reasonably well. Instead, he put it into bank deposits. The money was marked ” Sacred ” in his mental account. Had his uncle been extravagant may be Remesh would have played the stock market with the money”

After this, the author gives the impact of mental Accounting on Investors.

Impact of mental accounting on Investors:-

In this, the author gives, four examples of the impact of mental accounting

the author says, ” Mental accounting affects not only our personal finances but is more pronounced in the world of Investments.

  • Why do investors hold on to losing investments? They may offer various reasons to justify their action but the fact remains that mentally they are unwilling to accept that they are making a loss. Mentally we tend to believe that we book a loss only when we sell. Intellectually we recognize the loss but we hope that it will vanish. this is a common mental accounting error.
  • Why do investors earn less interest and pay more? Ravi is highly educated, has a successful career in margin trading, and is a savvy investor, in spite of the high interests paid by him, his returns from the business seem quite handsome. Being conservative he prided himself on having comfortable bank deposits to take care of any unforeseen eventualities. He knew that the bank deposits offered a lower rate of return but he felt that was a price he would pay for the margin of safety, that banks offered. It is ironic that he pays high interest in his margin trading while his own money earns a much lower interest in bank deposits. How much better he would be if he utilized his own money for his own stock trade and avoided paying such high rates of interest. this is not a stray case; most people make such mistakes. The problem is that they have two mental accounts. – ” Safe Money” and ” Risk Money ” – For the same money ( it’s also called mental accounting)
  • Most people believe that a bonus share is a freebie given by the company to its shareholders. they even buy moe shares on such news but they are dead wrong. Companies give bonus shares to capitalize reserves and balance their finances. But investors don’t see it that way they consider it to be a windfall. This leads them, to become extravagant. Most investors suffer from this mental accounting error that’s why the stock markets rise on such announcements.
  • Day traders trade in and out of a stuck time and again, with very narrow spreads. they think that they are generating income profitably. but consider the transaction costs and the brokerage they pay on such volumes. What they are in actually is the business of enriching their brokers. and the tax authorities. It’s like buying groceries not heeding the cost.”

Then the author gives the plan of action and advice

let’s see advice first

the author says, ” Before discussing the plan of action it is important to understand that there are no set rules. the best advice is to refrain from using credit cards and to treat all monies equally.

We all have our individual faults and we have to decide what we need to do for ourselves. mental accounting also has its positive and negative aspects and it is up to each individual to know what is best for him for instance, If you are a big spender and unable to curtail your urges, mental accounting could be the most effective way to plan your fixed mortgage payments kids education fund and retirement savings.

In order to eliminate the harmful effects of mental accounting while preserving  its benefits you need to audit your own mental accounting system.”

Then the author gives the plan of action for mental accounting, to avoid our loss

you can read this plan, in the book, buy the book, from the following link ( image)

so this is all about the mental accounting from chapter 7 of the book ” Stock to riches”

Decision Paralysis:-Stock to riches Chapter 6

Hello friends, in today’s article we see the decision paralysis bias from the book stocks to riches chapter 6. In this, the author i.e. Parag Parikh gives wonderful examples that help us to understand this concept. so if you have some decision paralysis bias, then you have to read this article, and understand it, to avoid the decision paralysis bias.

Previous Chapter 5

Decision Paralysis and The endowment effect:-

Decision Paralysis

for starting the author give wonderful examples, and then we try to understand the decision paralysis in detail, let’s start with examples,

Roopesh ( a businessman) has come to meet with Satish ( a portfolio manager).

Roopesh:- I am a businessman I have inherited from my father a portfolio of various stocks. He was an investor and he died five years ago. I’ve always wanted professional help on handling my portfolio as I know nothing about stocks and My own business keeps me busy.

Satish:- it would be a pleasure to construct a good portfolio for you. I have been in this profession for the last 20 years and have many high net worth individuals and corporates as my clients. could I have a list of your stocks?

Roopesh:- Here it is, Can we discuss it right now? I have already wasted five years doing nothing.

Satish:- At a glance, I can see that it is a very lopsided portfolio and drastic changes are required to balance the industry weightage. A number of stocks will have to be sold as they are not viable. Had you done something about the portfolio immediately after your father died you would not have been saddled with so many junk stocks? since we need to act quickly I will put my comments on this sheet. (Decision Paralysis)

Roopesh:- Oh, thank you so much for understanding the urgency of the situation and working on it the right way. I will get everything in order and meet with you the day after tomorrow.

Satish:- That’s may not be possible as I am extremely busy, how about next week?

Roopesh:- Satish, you know the urgency so please spare some time for me. I will adjust my schedule.

Satish:- Is 4. P.M. okay with you?

Roopesh:- It’s perfect. Thanks for squeezing me in I just need to get over this. I am so indebted to you for your time.

they meet at the scheduled time.

Roopesh:- I did some homework and I have a few queries.

Satish:- Please go ahead, I will clarify all your doubts.

The meeting goes on for an hour. Initially, Roopesh’s questions are the same but Satish is patient and clarifies all his doubts. the meeting ends with Roopesh scheduling another appointment after a couple of days.

Roopesh:- Thank you once again for your time You know how urgent this is for me so before I finalize I brought my wife along so that she too is clear about everything. Meet my wife Meena

Satish:- Nice meeting you. Now, what can I do for you? I hope your husband has explained everything to you. If you have any questions don’t hesitate to ask.

Meena:- I am just a housewife. I do not understand investments. My husband insisted that I come as he wanted to finalize some business with you. He told me that you are an expert in your field and he trusts you very much. I am happy that he has ultimately taken a decision after five years. (Decision Paralysis)

Roopesh:- Yes, I am glad I have met the right portfolio manager. now to complete the formalities and take action, shall we meet tomorrow? Please give me an appointment as this matter is my first priority.

Satish:- Okay. since we will require time to finalize, let’s make it 6 P.M. tomorrow.

Roopesh:- thank you very much. I will be there. I will bring my wife too in case you need her signature. goodbye.

The next morning, Roopesh calls Satish’s secretary and asks her to reschedule the meeting two weeks later, Roopesh walks in with a gentleman.

Roopesh:- Satish, meet my friend Atul. He is a leading chartered accountant. before finalizing. I thought he should meet with you and you can clarify his doubts. I hope you don’t mind.

Satish:- Yes, Atul please go ahead with your questions,

Atul:- I have heard a lot about you. I have nothing to ask a professional like you. I know Roopesh Is in safe hands. Roopesh, I know of Satish’s reputation and you can be assured that you have got the best professional working for you.

Roopesh:- thank you. Now Atul has given me the green signal I do not have any hesitation. I will call tomorrow and fix a time so that I can bring my wife and we can complete the formalities.

the next day Roopesh calls Satish’s secretary and asks for an appointment after three weeks as he has another urgent business appointment the secretary refuses to reschedule the appointment.

I know while reading these examples, we can’t get any logical sense, so read the following explanation to understand the logic of the above examples. (Decision Paralysis)

After these examples, the author explains about above examples.

the author says, ” Why did the secretary do that, especially after Satish had spent so many hours with a prospective client and the signing was a near certainty? What do you make of Roopesh’s behavior? Why was he post poring his decision? Suffers from decision paralysis. He can not make decisions and is resilient to change Satish had lost trust in him. He guessed that nothing would make him act. To buy time Roopesh went on a business trip, then bought his wife along, and after that his friend Atul. His wife and his friend were not even informed about the talk. He had had with Satish and neither was competent enough to ask Satish any worthwhile questions though Roopesh harped on the urgency of the matter and insisted that it was a top priority he just could not decide what to do. Perhaps he has been behaving this way earlier as well. He fears change, so he prefers maintaining the status quo.”

He understands that he needs to take action but he can not.

then the author explains decision paralysis or Status quo bias.

the author says, ” this phenomenon hampers us in many areas of life, from choosing an investment option to buying a house. Once you are familiar with the complicated forces at play you will understand why choice and change can be so intimidating.

A significant sequence of decision paralysis in financial decisions is that by deferring purchase you may miss the opportunities or run the risk of prices-rising. Imagine there is a very good house for sale. You like it because it suits all your requirements and the prices seem right. But you can not decide and opportunity to see a few more houses. With multiple choices a decision is difficult. As time passes another bidder enters the fray and you lose the opportunity. Because of decision paralysis, you lost the house.”

then the author explains, what factor needs to be making decisions.

Taking Decisions:-

In this author explain the different factors that need to take decisions

the author says, ” We have to understand that deciding not to make a decision is also a decision. when we make a decision we give ourselves a chance to have from the present comfort zone. Once we do that we have a 50-50 chance of going right or wrong. If we choose not to take a decision we miss this chance of going right.

Maintaining a status quo in times of continuous change is definitely unwise. Another way of looking at decision paralysis is that it is a natural human tendency to resist change.

So one is the reason that is why we can’t make the decisions.

  • Fear of going wrong
  • the possibility of losing
  • to avoid looking foolish
  • Unwillingness to take risks

then the author explain the above point

the author says,” All these reasons stem from our psychological and cognitive defects. the most acute of these is loss aversion and egocentric human nature. Along with that heuristics like regret avoidance and belief perseverance also play a significant role in our mental makeup”

then the author gives the illustration story to understand better way.

the author says, ” suppose, you inherit from your rich uncle Rs. 50 lakh and you want to invest it. You buy stocks, bonds, fixed deposits, etc. according to your preference and needs. It is simple you have the money and you allocate across assets. But if you were to inherit a portfolio of stocks amounting to Rs. 50 lakh, what would you do? you need to make multiple choices. You could sell the stocks in the portfolio and buy different stocks or some bonds etc. Or you could leave the portfolio as it is. Most people would choose to leave the portfolio as it is. they would choose to maintain the status quo. when there are multiple options. One is more likely to delay on action or take no action at all the greater the choice. The harder the decision.”

Then the author explains what is investing and decision paralysis relation.

Investing And Decision Paralysis:-

In this, the author gives examples to understand this relation between investing and decision paralysis in a better way.

let’s see examples

the author says, ” Decision paralysis plays an important role in Financial markets especially when you are dealing in the stock markets. the volatility of the stock markets also adds to distorted human behavior. Most people would do nothing or as well as we call it, maintain the status quo. Here are some examples of decision paralysis at work.

  • During the IT boom stocks reached new heights this went on for over a year. Those who invested in tech stocks become wealthly. a number of us, find managers and clients, thought that the markets were irrational and that the tech stocks were priced high. However, everybody wanted to ride the wave, confident that they would sell when the market softened. A fund manager of a leading mutual fund who also shared my opinion on the market. Valuations said he would sell when the tide turned. His fund had a weightage of 80 percent in the technology sector. When the market dropped it did not go down in one go. It was gradual before the steep fall come. Actually, the fund manager should have sold when the market began to weaken. He had been looking forward to such a situation, yet when the time come for him to do it he did not sell. He suffered decision paralysis and so did millions of other investors who made huge profits in the tech sector. I had consistently advised him to sell. He did not and suffered a loss when he liquidated.
  • We all remember the story of the unit trust of India ( UTI) the guardian to millions of Indian investors, corporate pensions widows working class, etc. Established in 1964 it was the only Indian mutual fund where Indians invested their savings. Operating in a socialistic environment the fund was open-ended but not net asset value ( NAV) based. It consistently distributed dividends and the governments supposedly guaranteed repayment. One could enter and exit at the price made available by UTI itself. Liberalization in 1991 and the entry of private and public sector mutual funds. Soon Challenged UTI’s supremacy. Despite operating in a competitive environment it continued to follow its earlier policies. In 1995 the stock markets boomed. that was the time to make it open-ended and let investors enter and get at the current NAV. times were changing and UTI’s position was threatened. The writing was on the wall but no action was taken. The Deepak Parikh committee was appointed to advise restructuring of UTI but nothing was done. Until one day the inevitable happened. this not only shattered the investors of UTI but also shook. the stock markets and it took over a couple of years for the markets to recover.
  • Another example of decision paralysis is when investors buy top-performing funds and do not reshuffle. their portfolios. they are happy since their funds are doing well. but when there is a choice of funds it is important to choose the right one, which may not necessarily be the one that has performed well. On the contrary, the chances of it sustaining its performance are much lower. By definition, a mutual fund captures the mutuality of the market so in the bull phase you should reshuffle. don’t let decision paralysis hamper your investment decisions.
  • Greed and Fear are a part of the market flow excess characterize the bull phase where every stock is sellable. During such a phase all types of companies enter the capital market to capitalize on the bull run. Money becomes easily available. Investors get trapped by such stocks when the bull run ends they swear they will get out of such stocks as soon as they can. For years they prefer to maintain the status quo as they get greedy, hoping to make more money on such junk stocks.

then on these examples, the author gives a short note.

the author says, ” I have come across various examples of investors who are unable to decide and prefer to maintain the status quo. why do people behave this way? Is the prospect of change so frightening? yes, it is and the concept of the endowment effect explains it all.

then the author explains the endowment effect

Endowment Effect:-

to understand this effect, the author gives the two situations, and their explanation.

The author says, ” What would you do in the following situations?

1 ) You have been gifted a souvenir jug worth Rs. 100 ( in the marketplace). Someone offered to buy it from you. What is the very least you would expect to be paid for the jug?

A) Rs. 100      

B) Rs. 80

C) Rs. 70

D) Rs. 50

second situation

2) Your neighbor has received a souvenir jug worth Rs. 100 ( in the marketplace) as a gift. he offers you the jug for sale. What are the most you are willing to pay for the jug?

A) Rs. 100

B) Rs. 80

C) Rs. 70

D) Rs. 50

It is obvious when someone offers to buy the jug from you, you would like to be paid Rs. 100. but when the same jug is offered to you, you would like to pay only Rs. 50 why is there such a big difference in the price offered and the price tendered when the person is the same and the jug is the name?

Because we perceive that whatever belongs to us is more valuable than that belongs to others. When something comes into our possession its value increases. In a way, this explains why people prefer the status quo to change by foregoing change in favor of the familiar they express happiness with the current situation. True, a decision to do or not to do something would be influenced by a host of other factors such as doubt, fear, or confusion.

Nonetheless, keeping things as they are is a vote of confidence for the current circumstances, irrespective of whether they are good or bad. a preference for holding on to what you have is a lot stronger than most people think.

because people place an inordinately high value on what they have, a decision to change becomes difficult. Of course, people do manage to overcome this tendency, for if they didn’t they would not sell their homes as trade their used cars, or divorce their spouses. but to the extent that the endowment effect makes it difficult, to properly value what is and isn’t yours, you may fail to pursue options that are in your best interest. In fact, the endowment effect is just another manifestation of loss aversion. people, place too much emphasis on instant gratification and too little value on Opportunity Costs.”

then the author talks about the impact of the endowment effect.

Impact of Endowment Effect:-

To understand this effect impact author gives us real-life examples, in that examples how the endowment effect is used. let’s see step by step

the author says, ” The endowment effect is very relevant to invest. Stock market participants, Analysts, Fund Managers, and companies all become victims of the endowment at one time or other. here are a few examples of the endowment effect as it plays out in real life.

Overvaluing One’s Holdings:-

Ganesh:- “ What is the price of Tata Steel?”

Broker:- ” It is Rs. 298/299 ”

Ganesh:- ” Give me a call when it reaches Rs. 300, I need to sell.”

the price reaches Rs. 301.

Broker:- ” The price is Rs. 301/302. Should I sell? It is one rupee above your limit of Rs. 300.”

Ganesh:- ” No. The market seems to be going up I will wait for a price of Rs. 305, give me a call then.”

the prices go up to Rs. 306 and the broker calls.

Broker:- “ The price is Rs. 306. What should I do.”

Ganesh:-“Wait till it touches Rs. 315. then don’t even ask me, just sell. I am sure it will go up. This is a great company and such a low price is ridiculous.”

the price falls to Rs. 301.

Broker:- “ The markets are down and the stock is back to Rs. 301.”

Ganesh:- ” The market may be down but the stock can not go down. I know we will get the price Tomorrow. when the markets are up. don’t worry we will sell tomorrow at Rs. 315. I just can’t believe that the market is selling a good stock so cheap.

After these examples author explain why Ganesh does that

the author says, ” Every time the stock went up Ganesh would increase his limit. Was he playing games? No. he is a serious investor. He strongly believes that Tata Steel is a great company. He is proud of his holding and he firmly believes that the market is undervaluing his stock.”

Other Examples

The Trial and Money-back Guarantee scheme:-

Raju:- ” Mom, see what I’ve got, the latest stereo system. It will fit perfectly in our drawing-room. Wait till I play it. you will love the sound.”

Mom:-” Raju, where did you get the money for such an expensive stereo.”

Raju:- ” it’s on a 15- day trial basis. the shop round. the corner allows you to use the goods before you buy. Since college is closed for two weeks. I thought I’d listen to some music at home.”

Mom:- ” Are you sure they will take it back without any fuss?”

Raju:- “ Of course mom, don’t worry. here is the card. It says that they will take it back no questions asked, it returned within the 15-day trial period.”

Mom:- ” that’s great, handle it carefully. They may not take it back if it is misused.”

Raju:- “ Don’t worry I will be careful.”

After 14 days,

Mom:- ” Raju, don’t forget the trial period ends tomorrow. we have to return it, though we will miss it.”

Raju:- ” Mom, can we keep it and make the payment A good system makes a difference. Moreover, it fits in with our decor like it was specially made for us.”

Mom:- ” Yes, you are right. let’s keep the stereo we will make the payment.”

so you get the idea of the endowment effect. (Decision Paralysis)

then the author gives us an explanation.

the author says,” Notice how taking a product on trial got Raju and his mother to buy it. the shop owner understands the endowment effect very well. he knows that once the stereo becomes a part of their endowment it will be very difficult for them to part with it. they did not find out whether the stereo is competitively priced, whether there are better models in the market, or whether some company has introduced a better model.

Because it had become a part of their endowment it become very precious to them.

Businesses understand the endowment effect too well that’s why they are willing to give their product on trial with a money-back guarantee on purchases. they know that once customers own the product, even if it is for a few days, its perceived value increases, and they may not want to return it.”

So for avoidance the investing mistakes by cause of decision paralysis and endowment effect.

the author gives us the perfect plan of action to avoid this.

so, if you want to read that plan, you can read that plan in this book, by ordering this book from the following image link

to Solve the following problems

  • You have a hard time choosing investment options.
  • you react adversely when your decisions turn out poorly.
  • you buy products on trial but never return them.
  • You delay making investment and spending decisions.
  • you hold on to stocks you own.
  • You go on a company visit and buy stocks
  • you do not have a retirement plan in place.

So, this is all about decision paralysis and the endowment effect.

I highly recommend buying these books, from the above link,

if you buy these books, you will avoid losing millions of money on useless things.

so then buy these books, and improve your investor behavior mindset.

Loss Aversion from Stock to riches Chapter 5

Hello friends, in today’s article we see chapter 5 from book stocks to riches by Parag Parikh. This chapter is all about two concepts i.e. Loss Aversion and Sunk Cost fallacy. lose aversion bias is the most famous bias that people use in their life and take wrong decisions. so let’s understand this concept and use it in our Investor journey.

Previous Chapter 4

Loss Aversion & Sunk Cost Fallacy:-

loss aversion

In this chapter, we learn about the most famous concept of psychology. before starting author give Warren Buffett ( great investor) and Benjamin Graham ( father of value investing) quotes.

” I will tell you how to become rich. close the doors. Be fearful when others are greedy, Be greedy when others are fearful.”    – Warren Buffett lecturing to a group of students at Columbia University.

” Most of the time, common stocks are subject to irrational and excessive price fluctuations in both directions as a consequence of the ingrained tendency of most people to speculate or gamble to give way to hope fear, and greed.”                        – Benjamin Graham ( father of value investing)

the author explains how this emotion actually works in the stocks market i.e. fear and greed

the author says, ” We have all heard that investors greed when the stock markets are in a bull chase and their fear when the markets are falling. It is important; therefore to understand how these emotions of greed and fear impact our thinking and make us act in ways that are contrary to our financial markets? How do we make decisions when faced with risk?  How do fear of losing and greed for gains impact our decision-making?

then the author explains, loss aversion and sunk cost fallacy

the author says, ” As far as our feeling toward our losses is concerned, we suffer from two behavioral Anomalies: Loss Aversion: that is our fear of losing, Sunk cost fallacy:- that is our inability to forget money already spent.

As far as our feelings towards gains are concerned, we suffer from status Quo bias that is our Inability to make decisions, and the Endowment Effect that is the tendency to fall in love with what we own and this resists change.”

after this, the author gives examples of loss aversion. you should read in the book, for that buy this book, from the following link

To understand more about the loss aversion concept, the author gives us two scenarios, this is a wonderful scenario, I bet if you will read it the first time, then you definitely give the wrong answer. (Stocks to Riches Chapter 5 on Loss Aversion )

the author says, ” let’s take a look at the following two scenarios.

Scenario 1:- you are given Rs. 1000 and two options

A) Guaranteed win of Rs. 500

B) Flip of a coin. If it’s heads you get Rs. 1000 and if it is tails you get nothing.

Which option will you choose? Now let’s go to Scenario 2

Scenario 2:- You are given Rs. 2000 and two options

A) Guaranteed to lose of Rs. 500

B) flip of a coin. If it’s tails you lose Rs. 1000 and if it is heads you lose nothing.

Which option do you choose?”

After this, the author gives the right opinion before that read this scenario again and keeping in mind your option.

then the author says,” Research Suggest it’s more than likely you chose option A in Scenario 1 because there was a guaranteed win of Rs. 500.

you acted conservatively and took the opportunity to lack in sure profits But in scenario 2, you would most likely choose option B because you did not want to be confronted with a guaranteed loss of Rs. 500.

Hence you were willing to take more risks if it meant avoiding losses. It is this bias that makes gamblers so popular with the casinos. (Stocks to Riches Chapter 5 on Loss Aversion )

Why is it that when confronted with a sure profit we become conservative and when confronted with a loss we tend to take more risks? it’s because the pain of a loss is three times more than the pleasure of an equal amount of gain.

Over time pain becomes terrifying and pleasure becomes boring. consider this, you get an electric shock while using your T.V. that will scare you and you will avoid going near the TV till the fault is set right.

Now contrast this with the pleasure you get when you buy a car for the first time. After a while, you get bored with it and you long for a better and bigger car. It never stops your desires keep upgrading because pleasure over time becomes boring.

We tend to see losses and profits in isolation and that is the reason we are more prone to suffer from loss aversion. Hence, we should not view different stocks or different classes of assets individually but as part of the portfolio as a whole.:

then the author gives examples of equity

the author says, ” suppose, there is a decline of 10 percent in equities and a rise of 8 percent in bonds, we should look at the overall effect which is only 2 percent. or take the case of a portfolio with 10 stocks, each valued at rupees one lakh. If two stocks depreciate by 50 percent, the overall effect on the portfolio is only 10 percent but if we were to look at the stocks in isolation we should see it as two stocks losing 50 percent in value that’s a big shock, and we could make decisions that we repent later.”

then the author gives the answer of before given scenario

the author says,” In the scenarios mentioned earlier if we looked a the final financial position after exercising the options, the automatic choice would be option A in both cases as it would leave us with Rs. 1500.”

then the author gives the impact of loss aversion

Impact of Loss Aversion:-

  1. Investors tend to prefer fixed income investments to stocks
  2. Investors tend to take their profits very early
  3. Investors take more risks when threatened with a loss
  4. Investors tend to hold on to losers and sell winners
  5. Tax Aversion.

1) Investors tend to prefer Fixed income investments to stocks:-

In this, the author says, ” witness the period of after the bursting of the dotcom bubble till the beginning of 2003, everyone was so afraid of losing that they preferred to stay invested in fixed income securities they shunned equities although that was the best time to invest because of attraction valuations and good dividends yields. the pain of investors losing fortunes in technology stocks was so vivid and true and true that investors were not willing to risk anything in the stocks markets. the emotion of fear was so strong it created loss aversion. Actually, the right time to invest is when others are scared.” (Stocks to Riches Chapter 5 on Loss Aversion )

2) Investors tend to take their profits very early:-

In this, the author says, ” To be successful in the stock markets it is important to ride the winners and discard the losers. However, loss aversion makes us ultra-conservative so we book profits very early. we all suffer from loss aversion and that is the reason we find that winners get a small number of profits and losers pile up huge losses. winning streaks tend to be short-lived.”

3) Investors take more risks when threatened with a loss:-

In this, the author says, ” They tend to lose their balance. when confronted with a loss and become more daring and venturesome. this is not due to courage but because of madness caused by the pain of a loss.

One of our clients bought 10 low-valued stocks all quoting below par. when I questioned his wisdom in putting his hard-earned money in such stocks he replied that if just a couple of them turned out to be multi-baggers he would make good money he believed so strongly in his strategy that he held on to over a hundred such junk stocks in the hope that one day he would make it big. since he was losing he kept taking bigger risks and increased his exposure.”

4) Investor Tend to hold on to losers and Sell winners:-

In this, the author says, ” A portfolio of stocks with a few winners at the top followed by a long list of losers is not uncommon. as discussed earlier, it is because we go for sure gains and take more risks when threatened with a loss. so if you have one such portfolio you need to know that your decision-making is being controlled by loss aversion. Instead of riding the winners, you are riding the losers.” (Stocks to Riches Chapter 5 on Loss Aversion )

5) Tax Aversion:-

in this, the author says, ” People are always wary of paying taxes. this is also one sort of loss aversion tax is an outflow and it is considered to be a loss but in reality, we pay tax on our income we need a change of mindset. always count your income net of taxes this will enable you to avoid tax aversion arising out of loss aversion.”

then author explains about the Investors, after giving the impact of loss aversion

the author says, ” the idea that investors are not risk-averse but loss averse is one of the main tenets of behavioral finance. while the distinction might seem trivial; studies have shown that investors will increase their risk, defined in terms of uncertainty, to avoid the smallest probability of losses. it is not so much that people hate uncertainty, but rather that they hate losing.?”

Friends, this concept looks easy, and you think that that’s only, I know already, but from my experience when we include our hard-earned money, then we go in this loss aversion concept, and most of the time we lose.

So I recommend you to be cool and don’t say, it easy, this is not easy, it’s simple, and simple things is not easy

so let’s come to our topic

then author explains our Sunk Cost fallacy concept

Sunk Cost fallacy:-

To understand this concept, the author gives some examples, that we use in daily life, and how sunk cost fallacy occurs in our daily life.

examples 1)

Investor:- I have invested in Sterilite Optic, it is a great stock. I have read about the telecom boom and I am sure this is right.

Broker:- the telecom crazy has ended, there is overcapacity and the story is over the stock is going down as the industry fundamentals have changed.

Investor:- so what, I will buy more and bring down my cost of purchase. I know it was a great stock please buy 2000 Sterilite Optic.

Examples 2)

Housewife:- I thought investing was fun so I enrolled in these classes. I think I have made a mistake as I feel I am not cut out for this. but I will complete the course as I have already paid the fees and they don’t have a refund policy. (Stocks to Riches Chapter 5 on Loss Aversion )

Example 3)

Student:- I am not interested in commerce. I took it because I wanted to be with my friends. I know I have made a big mistake. But since I have already completed three years I would rather complete the rest and take the degree.

Example 4)

Businessman:- In the last two years, I have spent so much money on car repairs, I would have been better off buying a new one.

Examples 5)

Teenager:- Oh, what a boring book, I should not have wasted my money on it. With great difficulty I read the first 30 pages, I still have 400 more pages but I hope to complete that by the end of this week.

Example 6)

Day Trader:- it’s really tough to make money in such volatile markets. I should not have got this terminal at home. It’s a fixed expense every month, I have to trade every day so that I can at least recover my fixed costs.

After these awesome examples the author gives the two scenarios, just like the loss aversion concept scenario, and after that author gives the above examples, which is right and what should we have to do right for them.

the author says, ” why do people do what they do not like? Is it not simpler to choose not to do it? Now, what would you do in the following two scenarios?

Scenario A:- You have complimentary tickets for a Filmfare awards night. On the evening of the program, there is a severe rainstorm, and traffic is disrupted due to floods. You have to travel from Colaba to Andheri.

Would you go? Yes or No

Scenario B:- You have bought a ticket for a Filmfare awards night for Rs. 1500 on the evening of the program there is a severe rainstorm and traffic is disrupted due to floods. You have to travel from Colaba to Andheri.

Would you go?  Yes or No

Choose your answer wisely,

then the author explains, what is the sunk cost fallacy concept and behind this scenario how these works.

and also explain the psychology behind this scenario

the authors say, ” Most people would go for the show if they had paid for the tickets and would avoid it if they had received the same as complimentary. actually, this distinction makes no sense as the money for the ticket is already spent. you will not get it back whether you go to the event or not. What we must really look at is the additional risk we are taking by braving the Strom and the additional costs we may incur if the car is damaged or we fall sick. the danger posed by the rainstorm is the same, whether the tickets are free or paid for.” (Stocks to Riches Chapter 5 on Loss Aversion )

This particular type of loss aversion to which we all are prone is what Richard thaler described as the Sunk Cost Fallacy.

You increase your commitment to justify your past actions because your ego is tied to be commitment.

then the author explains Sunk Cost Fallacy, for the previous six Examples

the author says, ” Let’s go back to the statements given earlier

  • the investor make a decision and does not want to admit that his decision has gone wrong. so to justify it he buys more stock and takes solace in that he is bringing down his cost of purchase.
  • The Housewife goes through the ordeal because she is already enrolled. She does not consider the extra time, energy, and money, by way of transportation, she will spend to fulfill the original wrong choice.
  • the student takes his graduation because he has already completed three years, would he really learn much when he is not interested in the subject?
  • The businessman should have recognized that there is something like the economic life of a car rather, he chose to continue spending on repair as every time a new expense come up he thought of the previous repair cost and thus went on and on.
  • A teenager has already spent on the book, so he will finish it however boring and time-consuming it is.
  • the day trader operates a business he knows will fail, but since he has already incurred fixed expenses he will keep going.

then the author says, ” each of them had a choice, to do or not to do. However, they considered doing what they don’t like because they wanted to justify their previous actions, also, they did not want to appear wasteful and incompetent in their financial decisions.

But Sunk cost Fallacy can also help us in a positive way. for example, a person joins a gym vowing to work out regularly. Instead of paying daily charges if he were to take a yearly membership, the sunk cost fallacy would help him to be regular, as he has already expended the year’s fees. This serves as a motivation to keep going.”

then the author explains, what impact of sunk cost fallacy

Impact of Sunk Cost Fallacy:-

1) Averaging Cost of Purchase

2) Spending on Repairs

3) Government Spending on Unviable project

let’s understand one by one

1) Averaging Cost of Purchase:-

In this, the author says, ” generally, when investors go wrong in their purchase of stock they buy more at every fall. they believe that this will bring down the cost of their purchase. there is nothing wrong with that, provided they are confident that the stock has great value. But if they buy only to justify past actions, then they are prone to sunk cost fallacy.”

2) Spending on Repair:-

In this, the author says, ” Two years ago you pointed your old car. last year you replaced the tires and changed the suspension. this year the mechanic informs you that the engine needs an overhaul. every year you justify your spending on repairs because of earlier expenditures when actually you need to discard the car as it has reached the end of economic life. Maybe it is wiser to buy a new car. spending on repairs is a common sunk cost fallacy with most of us.”

3) Government Spending On Unviable Project:-

In this, the author says, ” Bureaucratic procedures have delayed a project and it has now become unviable but a lot of steel and cement have already reached the site and the plants are ready. The initial fees of the engineer have been paid. Since so much money has already been spent the project is completed even though it is unviable. this is how sunk cost fallacy works with the government”

then the author gives examples of how the sunk cost fallacy occurs in day-to-day life.

the author says, ” the influence of sunk cost fallacy is evident in our day to day lives. How many times have we not sat through a boring movie just because we had bought the tickets? Here are some examples of the impact of sunk cost fallacy

At a buffet (the system used in an event to provide foods) there are a variety of dishes as the restaurant has to satisfy the palates of different types of people. Instead of exercising our choice, we tend to overreact only because we have paid for it. that is sunk cost fallacy working on us. the next time you go to a buffet, remember your health is more important than indulgence.”

It is not enough to understand the two behavioral anomalies of loss aversion and sunk cost fallacy. We have to recognize our own anomalies so we can improve ourselves and become better investors. (Stocks to Riches Chapter 5 on Loss Aversion )

So this is all about Loss aversion and Sunk Cost Fallacy concept.

In this chapter, the author gives the suggestion to become a better investor, I think you should read this in the book for you can buy the book from the following link

lastly, the author gives some questions to understand you are the victim of loss aversion and sunk cost fallacy

answer the questions

  • Do you prefer fixed income securities overstocks
  • Are you tempted to move out of the markets when the prices fall?
  • Does your portfolio consist of a few winners followed by a long list of losers?
  • Do you sell your winners fast and hold on to losers
  • do you make important spending decisions based on your past spending?

then the author gives the right answer

the author says, ” if your answer is yes, then you are a victim of loss aversion and sunk cost fallacy.

then the author gives suggests avoiding being a victim or loss aversion and sunk cost fallacy.

buy this book, from the above image link, and improve your portfolio performance.

Stocks to Riches Chapter 4:- Introduction to Behavioural Finance

In today’s blog, we see the introduction to behavioral finance from chapter 4 of the book stocks to riches by Parag Parikh. This is a wonderful chapter you should understand how our feeling is work in the stock market and how can we have to get precautions.

so let’s start

Previous chapter

Introduction to Behavioural Finance:-Stocks to Riches Chapter 4

Stocks to Riches Chapter 4

In this chapter 4, the author explains behavioral finance with wonderful examples

let’s start with examples of peoples behavior

  • “With such positive news from the company why is the stock going down”
  • “I am a qualified chartered accountant. I went through the finances of the company and I feel that at the current price, the stocks are too expensive. I would not buy it nor recommend the same to anybody. But I am surprised that in the last two weeks the stocks are up 15 percent.”
  • “My friend works with this company. they told me that it was doing exceedingly well and that they have an export order worth crore in hand so I bought the stock. It’s six months and I have been waiting but the stock is going down.”
  • ” the company has announced a 1:1 bonus, it’s good news so I bought the stock but the stock went down instead of going up like I thought it would.”
  • ” I read the mornings newspaper and was impressed by the finance minister’s speech and his intention to give sops to the economy. the markets greeted the news positively and went up so I bought stocks the next day the markets were down for no reason and I lost on my investment.”
  • ” I heard the expert’s comments on T.V. on the current budget presented by the finance minister. they were not very happy with it. I sold my stocks only to find that within a week the markets were up 10 percent. I don’t know why I sold my stocks which I had been holding for the last four years.”
  • ” I can not understand the markets. I would rather stay away.”

after his behavioral statement, then the author tells, how this statement happens

the author says, ” Aren’t all these statements familiar you have heard them on perhaps made then yourself. In an ever-changing and uncertain world, we are trying to find some predictions where none exists. The easiest thing to do is to avoid such irrational markets. But then you would be missing out on one of the most favorable modes of investment. (Stocks to Riches Chapter 4)

My sincere advice would be to catch the bull by the horns. confront the problem rather than run away from it. Try to understand why it is happening to you.”

then the author gives their own experience, in dot com bubble time.

the author says, ” during the IT bubble. Too found myself bewildered and confused. The valuations of the dot-com businesses and IT stocks seemed highly inflated. Pundits in the market and the media were pontificating on the new economy and giving convoluted justifications for what was approved to be sheer insanity. I wondered, was the entire world mad and I the only left the same, or was I insane and the world perfectly rational?

I had a client who had invested around 70 lakhs in different IT stocks in 1998 on his friend’s recommendations in 1999, his portfolio value was around Rs. 5 crores when he asked for my advice I told him, to sell as I thought that the PE multiples were very high and the valuations seemed for too stretched.

He did not do so and six months later when we met he informed me that the portfolio value was around Rs. 6 crores. Once again he asked me what he should do I was a bit embarrassed by the question, as I knew that he was, not asking for advice. but telling me indirectly that I was not in sync with the markets. I still insisted that he sell but he did not sometimes later the portfolio value went up to Rs. 8 crores.”

then the author explains why they 3 times give the wrong advice and his friend portfolio value is growing continuously.

the author says, ” this was the frustration I had to go through, of being in the investment business and not able to advise clients correctly. there were times I had sleepless nights fearing that the world was going too fast for me to understand. I doubted my abilities, my competencies, and my knowledge. (Stocks to Riches Chapter 4)

The inability to understand the madness added to the frustration. In fact, I lost quite a few clients as they thought that I was too conservative and not in tune with the new economy.”

then the author tries to find out the answer, for the above going wrong, why this happens

the author says, ” find an answer to this question I did some serious soul searching. my quest led to a fledging little know field called behavioral finance. ”

then the author explains, how emotions change and he is right with his decision, the only people, driven by their emotions. to understand this, the author gives good examples of true stories

the author says, ” this is a true story of a friend who ran a coaching class with one of his colleagues they started off well and within a couple of months they were full to capacity after six months, few students complained to my friend about his colleague’s rude behavior.

The allegation was that he was very short-tempered and arrogant. they wanted him removed or else they would discontinue the classes. My friend was worried. this colleague was his partner and he could not be removed. Moreover, he was a brilliant professional and an able tutor.

After a couple of weeks, the colleague fell ill and was absent for some time. the students were very happy. they thought that they had been successful in removing him.

one day my friend learned that the colleague had a brain tumor and needed an operation. this news shocked my friends, as now his partner would be out of action for quite some time. He informed the students of this calamity. the students were stunned and this shock changed their attitude. Hatred and resentment gave way to empathy and love. they visited him at the hospital and took him flowers. they repented their stand and prayed for his early recovery so that he could come back to teach.”

then the author told, what is the purpose behind this story.

the author says, ” purpose of this story is to understand that is humans we are emotional beings and our behavior and decisions are guided by our emotions. Frequently emotions prompt us to make decisions that may not be in our rational financial interest. Indeed decisions that enrich us emotionally may impoverish us financially.” (Stocks to Riches Chapter 4)

Behavioral finance is the study of how emotions and cognitive errors can cause disasters in our financial affairs.

then the author explains, Classical economic theory vs behavioral economic theory.

Classical Economic theory V/S Behavioural Economic theory:-

the author says, ” Classical theory talks about the efficiency of the markets and people making rational decisions to maximize their profits. It assumes that the markets are efficient and no one can take advantage of its movements. It also assumes that humans are rational beings and will act to maximize their goals.

However behavioral economists believe that the markets are inefficient and human beings are not rational beings.”

then the author, give the examples

the author says, ” Consider the examples if you and I were walking down a busy street in Colaba and you said you saw Rs. 5 coins on the road. I would say it is impossible. so many people walk this read and the markets being efficient someone would have definitely picked it up.

But in reality, we do come across such instances. this shows that the markets are not as efficient as they seem to be further, if we assume that people make rational decisions to maximize profits then how do we explain people giving to charities or throwing a party to celebrate a birthday or an anniversary?

Definitely, this is not about maximizing profits by rational people.

here’s another example of how irrational we can be. the acronym Tips:- stand for To Insure prompt service

If TIPS ensures good service we should be tipping before the service starts. Yet, we give tips at the end of the meal. We even give tips when the service is substandard. (Stocks to Riches Chapter 4)

Tipping is more a custom, we do it mechanically unaware that we are behaving irrationally. yet, in economic theory we are rational beings always intent on maximizing our economic status. this is a common mistake we make without realizing its pure economic implications.”

after this, the author explains behavioral finance and why we react like this.

the author says, ” Behavioural finance researchers seek to bridge the gap between classical economics and psychology to explain how and why people and markets do what they do. Behavioral finance raises a couple of important issues for investors. the first is whether or not it is possible to systematically exploit irrational market behavior when it occurs.

The second issue is how to avoid making sub-optimal decisions as an investor. the goal is to close the gap between how we actually make decisions and how we should make decisions.

  • Hold on to stocks, that is crashing
  • Sell stocks that are rising
  • Ridiculously overdue and Underdue stocks
  • jump in late and buy stocks that have peaked in a rally just before the price declines.
  • Take desperate risks and gamble wildly when our stocks fall.
  • Avoid taking the reasonable risk of buying promising stocks, unless there is an absolutely ‘ assured ‘ profit.
  • Never find the right price to buy and sell stocks.
  • Prefer fixed income overstocks.
  • Buy when we have to sell and sell because others are selling.

then the author explains, how psychology plays a wonderful role.

the author says, ” Psychology can play a strategic role in the financial markets, a fact that is being increasingly recognized.

Students and proponents of behavioral finance create investment strategies that capitalize on irrational investor behavior. They seek to identify market conditions in which investors are likely to overreact or under react to new information,

These mistakes cause underpriced or overpriced securities. The goal of behavioral finance strategies is to invest in or disinvest from these securities before most investors recognize their error, and to benefit from the subsequent jump or fall in prices once they do.”

then lastly author gives the three sources of Alpha for superior performance.

i think you should read this in the book, for buying the book, visit the following link

 

so this is all about the Introduction of behavior finance, from chapter 4 of the book Stocks to riches.

Ways of Investing

Hello, friends in today’s article we see chapter 3 from the book, Stocks to riches. In this chapter, we learn three ways of investing. let’s see them one by one.

Previous Chapter

Three Ways of Investing:-

there are three ways by which an investor can invest to achieve superior results.

1) Intellectually Difficult

2) Physically difficult

3) Emotionally difficult

let’s see first is an Intellectually difficult path

The Intellectually Difficult Path:-

the author says, “An investor like Warren Buffett, Charlie Munger, John Templeton, and a few others have taken the intellectually difficult path of beating the markets. this path is pursued by those who have a profound understanding of investing can see future trends clearly, and can comprehend business and the environment. they know that Patience is a virtue and therefore take a long-term position.

We admire them but usually in retrospect initially, we may see them as being misguided but that is only because of our inability to grasp their point of view.”

then the author explains the method that helps this big investor to become big.

this method’s name is cashflow.

Those are big investors, they see how businesses work, their economic policies and market forces that affect the business environment, and how businesses show the cash flow. So this is the most difficult path, and it required a keen mind to study the different concepts of investing.

the author says, ” A good grasp of the various fields of management is required to understand the organizations and their ability to capitalize on various business opportunities. Good knowledge of the field of liberal analysis is basic to the development of various investment concepts.” (Ways of Investing)

then the author explains the name of the game in investing to get a superior return.

the author says, ” Here the name of the game is Patience. Such investors are always on the lookout for good opportunities and bargain prices. As long-term investors, they are willing to wait for them. they are not perturbed by events news rumors and gossip that create short-term volatilities.

They have a strong belief in their abilities since their goal is investing long-term for cashflows. As against capital gains, they are in no hurry to invest. They strongly believe that opportunities are always there but that when the biggest of them come, one must have the money to invest.

They are therefore very careful about allocating resources. They never buy on impulse. They can be out of the market for months, even years. they have the patience to wait till the right moment. Brokers usually do not like such investors as they do not churn their portfolios regularly.”

Then the author explains Intellectually investor qualities.

the author says,” Intellectually investors are also emotionally strong. that is the reason they are able to exercise such restraint.

we all want to be such investors but we cannot as we believe that we are not allowed intellectually blessed as they are. This is a wrong notion. the reason they are intellectually capable is that they work hard and make effort to reach that stage.

They constantly explore opportunities by talking with management, examining different viewpoints on business, trying to understand economic policies and their effect on business environments, etc.

their intellectual capability is derived from their hard work and their strong belief in the long-term approach to investments. Moreover, they use common sense in their judgments and are not swayed by rumors.” (Ways of Investing)

so these types of intellectual qualities you should practice to get a superior return.

then author talk about the second difficult  path is The physically difficult path,

The Physically Difficult Path:-

then the author explains, how we have to do work physically to get the proper investment opportunities, for that author gives the following explanation.

the author says, ” Most people are deeply involved in the physically difficult way of beating the market. they come early to the office and stay late. they do not know what their children are doing as they don’t have time for them.”

the author explains the whole things that regularly fund manager does each and every day of life. And this type of doing is the same as the other fund manager is doing.

then the author explains, why these people do this, and also gives their own experience on the physically difficult path.

the author says, ” In my experience, in the stock market dealing with fund managers has been really amusing. they sincerely believe that keeping themselves busy this way makes them look important and increases their ability to pick up the winners. Once I was at the office of a fund manager and we were chatting informally The telephone rang but he did not answer it. after a couple of rings, the call went to the answering machine. This is how most of them behave. show the world they are busy.”

then author explains how the day trader has also a physically difficult pathway.

the author says, ” the day traders also take the physically difficult path of investing. they spend the entire day collecting information and making decisions based on that information. (Ways of Investing)

so, with all the fund managers and the day trader trading the same path, how can any one of them achieve better results.?”

then author explains how good opportunities come, and what we have to do physically difficult path.

the author says, ” Good opportunities come once in a while and you spot them only when you are cool and have the time to think. The physically difficult path is based on the assumption that there are a lot of opportunities out there and you have to keep digging hard to be successful at investing. the current volatility in the market is the result of too many people trying to invest by this method.”

Life is simple. we make it complicated.

then the author explains the third difficult path and its most important and difficult path, if you master this way of investing then you are 90 percent ready to get a superior return.

The emotionally difficult Path:-

the author says, ” Most of us may find the intellectually and the physically difficult paths too daunting. In that case, we could opt for what is called the emotionally difficult path. Actually, this path is very straightforward. Simply work out, a long-term investment policy that is right for you and be committed to it.”

then the author explains how people think and act on the television news and rumors happening in newspapers, you can read, by ordering this book, link in below image.

after this author gives one example

the author says, ” If one were to compound money at a modest rate of seven percent the money would double at the end of 10 years and it would be 16 times at the end of 40 years.

Patience also helps you to control transaction costs. the more you churn your portfolio the more you pay the broker in terms of brokerage and of course the government in terms of taxes on your capital gains.

then you also have costs like depository charges, transactions tax, and service tax. all these costs would be avoided if one has Patience.

The emotionally difficult path requires an understanding of how our emotions guide our decision making especially when we deal with money. Our emotions directly affect our decisions on investments and expenditures.

We have to learn to think with our emotions rather than have our emotions do the thinking. understanding our own anomalies as also that of others will help us become better investors.” (Ways of Investing)

In the next fourth chapter, we will learn how to use our emotions to our benefit.

lastly, the author explains why is investing so difficult.

Why is investing so difficult:-

the author says, ” the most difficult part of investing is understanding the behavior of the stock markets. Market fluctuations are based on the varied opinions expressed by its participants, which in turn are subject to change commensurate with the changing sentiments of people.

it’s the crowd behavior that dominates the decision making and it is responsible for the sudden changes in the sentiments. take for instance.

The black Monday in May 2004. the markets lost around 700 points when the elections brought Congress to power.

What precipitated this huge fall? had anything gone drastically wrong with the performance of the companies whose stock prices crashed?

Definitely not. but the sentiments changed the BJP being voted out of power was a big change and normally we do not like changes.

Hence there was gloom all around and people dumped stocks as though there was no future. The herd mentality was at work and the markets crashed as each one wanted to get out faster than his neighbor.

If you were emotionally strong and you had bought when the others were panicking, you would have ended up making a huge fortune. (Ways of Investing)

But this seems easy only in hindsight. At that point in time going against the crowd is the most difficult but the most sensible thing to do. Understanding behavioral science is the key to success in this financial market. Its application not only helps you control your emotions but also helps you to understand others’ emotions and benefits from their mistakes.”

On emotion, Warren Buffett has a quote

“ If you can’t control your emotion, then you can’t control your Money”

so emotion is the main part of investing.

so this is all about the ways of investing from the book, ” Stocks to riches ” by Parag Parikh