Mental heuristics In Stock market

Hello friends, I am Laxman Sonale, In today’s article, we see chapter 8 from the book Stock to riches ( mental Heuristics). In this chapter the author, Parag Parikh explains how our mind is working in real life as well as in the stock market. Especially when money comes. So if you want to avoid losing money, then read this article, and understand it carefully.

let’s start

Previous Chapter 7

Mental Heuristics:-

At the start of this chapter, the author gives the two questions to test our mental heuristics, hey guys questions are so funny and logical, let’s see

Question 1:- Three birds are sitting on a tree, two decide to fly away. How many birds are there on the tree?

Question 2: Observe the following picture which line appears longer?

The bottom line appears longer but if you look at the diagram below you notice that both the lines are of the same length.

To support the above statement, the author gives the following diagram

 

the author gives the right answer to the first question

the author says, ” Although both the lines are the same why is It that the lower line appears longer? that’s because the brain takes a shortcut when processing information. I do not process all the information and this leads to biases. this process is known as mental heuristics.

If your answer to the first question- How many birds are there on the tree!- is one,

then you have fallen prey to mental heuristics. your brain does not the information properly. The answer should be three birds. Two had only decided to fly away.

They did not fly away had I told you that they flew away then you would be right.”

The first time I read it, I am also falling in bias

then the author gives the definite definition of mental heuristics and explains mental heuristics with examples

the author says, ” the dictionary definition of the word heuristics refers to the process by which people reach conclusions usually by trial and error.

This often leads them to develop thumb rules, But these are not always accurate. One of the greatest advances of behavioral psychology is the identification of the principle underlying these thumb rules and the errors associated with them.

in turn, these rules have themselves come to be called heuristics. In short, the following four statements define heuristics bias

• People develop general principles as they find out things for themselves.
• People rely on heuristics to draw inferences from available information.
• people are susceptible to certain errors because the heuristics used are imperfect.
• People actually commit errors in a particular situation.

Then the author gives examples of this

the author says, ” there is a newly opened megastore in the vicinity whose stock is listed on the stock market. you see a big queue outside it and you think it must be doing a roaring business.

You buy the stock hoping it will go up because the store is doing well. But there could be umpteen reasons for the queue the store definitely could be doing great business. But it is also possible that customers are queueing to return defective goods or perhaps the service is slow, or maybe all the other stores in the vicinity are closed on that day.

There are various reasons for the queue but our brain does not weigh all the probabilities and makes a decision on half-baked information.

Stock markets are interesting because Investors do this all the time.

then the author explains with reliance industries limited ( RIL) examples

the author says, ” when the company discovered a gas vein. the stock jumped as investors cashed in on this news. But let us analyze the situation without falling prey to mental heuristics.

the gas source was discovered but there were other factors to be considered the quality of the gas, the number of wells to be drilled, the time it would take, the plans to finance the project, etc.

Before the profits could be repaid yet analysts predicted the future profitability of RFL and on such hopes, investors bought the stock at rising prices.

This is how mental heuristics work when the brain does not process all the information and its implications. the tech boom was built on the same logic and we know the damage it has done.”

then author explains why we do this time by time,

the author says, ‘ Evolutionary forces shaped human cognition over centuries. that served our ancestors well, allowing for quick quality decisions.

Today, the complexities of our lives throw up multifarious data that sure minds may not assimilate very easily. The heuristics we help carry associated biases, which undermine the quality of our decisions. let’s take a look at some heuristics and their biases.”

then the author explains different heuristics

let’s see one by one

Availability heuristics:-Mental Heuristics

In this, the author says, ” One bias associated with availability is the ease of recall.

We are more likely to make judgments based on recent or easy-to-remember events rather than other similar but harder to recall instances. the flow of information around us is what happened in the India shining story of 2003-04.

All available information press, television, bureaucracy, business, and political circles, centered on the positive aspects of the Indian economy.

No negatives were permitted. shared by so much optimism the herd mentality comes into play and everyone not only believed the story, they advocated it.”

then the author explains, how these availability heuristics work in the stock market

the author says, ” this was reflected in the stock markets, the senses jumped from 2800 in April 2003 to over 6000 in April 2004. the NDA and its allies were sure they would win the electrons as the India shining story pointed a rosy picture of their governance. come May 2004 and the electron results announced that the NDA government had lost. How did this happen? the post-analysis revealed that the India shining story had been aggressively sold in the major cities; hence the exit polls in these cities placed the NDA’s chances very high. But 70 percent of the population lives in rural areas and for them, India was not shining. thus NDA was lost. (Mental Heuristics)

On may 17, 2004 the markets crashed by more than 800 points in just two days.

The reason:- All available information was negative. In bull markets, there is only positive news and in bear markets, it is only negative. that’s why markets go up or come down on reflexivity.”

then the author explains other heuristics, let’s see how they work in the stock market.

Representative Heuristics:-

In this, the author says, ‘ We assess the likelihood of an event by its similarity to other occurrences A predominant bias associated with this is an overreaction.

In the stock market, if the leaders report impressive performance, then all the stocks in that particular sector benefit.

the fortunes of the steel industry seemed to be changing and TaTa steel reported increased earnings profits. All the stocks in the sector including the junk and penny stocks attracted investors interest irrespective of whether they too would report increased earnings when the textile industry reported good profits, not only did all the stocks in that sector rise but companies in associated industries, like machinery manufacture, spinning mills, dyes, and chemicals also attracted attention. (Mental Heuristics)

Representative heuristics also affect investors’ actions. Investors try to replicate their portfolios by following the leaders. if they find that a leading find or broker or a respected personality has bought a particular stock they also buy the stock. in a way, this gives rise to the herd mentality.”

then the author explain saliency heuristic

Saliency Heuristic:-

In this, the author says, ” Individual over regret to un unusual event assuming it to be a permanent trend. Two airplanes crashed into the world trade center and the world stays flying the next day. Surely this type of incident has the next day. On the contrary, the next day was probably the safest time for flying.

In bull markets, analysts overreact to unusually good quarterly earnings assuming it would be repeated in the future and become bullish on the stock. In the bear market, they overreact to a bad quarterly estimate extrapolating it too for the future.

In 2004 second-quarter GDP growth estimates of 10 percent saw the markets going up on the assumption that the trend would continue. Actually, it needs to be sustainable to justify good times ahead, however, this is how saliency heuristic works with investors.”

then author gives overconfident examples, you can read this in the book, buy this book from the following link

then the author explain herd mentality with example in the stock market.

Herd Mentality:-Mental Heuristics

in the author says, ” Prakash bought a Maruti Western after carefully researching the decision. He was very happy with it and, enjoyed driving the car on his long haul trips to Lonavala. After a few months, a flood of strangers approached him and offered to buy the car at reduced prices.

The vehicle was in good condition and had done a few thousand miles. Worried that he had not made the right decision Prakash considered selling his Maruti at half his cost price. should he sell the car?

Before you answer, ask yourself what advice would you give him if he wanted to sell 1000 shares of Maruti, which he had bought for Rs. 400 and was now quoting at Rs. 300 due to depressed stock market conditions.

The history of the stock market shows that most investors buy stocks in companies or mutual funds for presumably sound reasons but exit their holdings the moment the market turns against them. (Mental Heuristics)

they sell when a bunch of complete strangers offers them less than what they had paid. Conversely, they will pay high prices for stocks or real estate, or paintings just because other people whom they don’t even know are willing to pay such prices. The dot-com boom was a result of such thinking.

In Stock market Parlance this is known as investing with the herd. We need to understand the manner in which the value of a stock or commodity is determined. To some extent what other people think matters a great deal.

Beauty may be in the eyes of the beholder but the value is often in the eyes of the buyer. If Prakash wanted to sell the Maruti then it was worth what the buyers would pay for it. But if he didn’t then he was the only one to decide the value of his car.”

then author explains how herd mentality work in the stock market

the author says, ”  In the stock markets most often investors allow popular opinion and behavior to define value for them; sometimes for the good but often not their buying or selling decisions are made not on the basis of their own convictions, but on the value that strangers appropriate.

The Herd mentality affects business decisions to a great extent people try to replicate the leaders. In the end everyone behaves alike which leads to cutting prices for market shares. This is very common in the stock brokering business.

Technology has made it easy to install trading terminals across the country. So to survive in a competitive market, brokers have lowered their trading commissions to as little as 3 paise. the difference between one broker and another is the difference in their commissions, not in the value they offer their clients.

that how herd mentality works in business.”

after this, the author gives the size bias

Size Bias:-

In this author talk about two friends, that invest in the market with different time frame, let’s understand size bias.

Two friends, Gautam and Salman, are just out of college and have taken up jobs. from day one Gautam sets aside Rs. 300 every month, which earns him 10 percent per annum, after 10 years he stops as he has started a family.

Salman got married early and did not save anything for a long while. After 10 years, he began to set aside Rs. 300 every month earning him 10 percent per annum.

He continued doing this for the next 30 years until he retired at the age of 60. Salman’s investment was Rs. 1,08,000 while Gautam’s was only Rs. 36,000

When both retired who has more money? it would seem to be Salman as he has been saving for 30 years. in reality it was Gautam. (Mental Heuristics)

At 60,  Gautam got Rs. 1,051,212 while Salman got Rs. 621,787. This is the power of compounding which investors normally forgot.

Salman could not make up for the 10 years that Gautam’s money compounded at an annual rate of 10 percent per annum.

We often tend to look at the big numbers and ignore the small ones.

In money matters, it is the small figures that make all the difference.”

After this author gives the wonderful advice to the trader, how their mind works, and how they recognize patterns.

this you can read in this book, buy the book from the following link.

So this is all about chapter 8 on mental heuristics from book stocks to riches by Parag Parikh.

Read More related articles

1. The Intelligent Investor book summary
2. Security Analysis Book summary
3. Common Stocks and Uncommon profits book summary
4. One Up On Wall Street book summary
5. Rich Dad Poor Dad book summary