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.
Loss Aversion & Sunk Cost Fallacy:-
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:-
- Investors tend to prefer fixed income investments to stocks
- Investors tend to take their profits very early
- Investors take more risks when threatened with a loss
- Investors tend to hold on to losers and sell winners
- 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.
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.
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 )
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.
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.
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.
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.