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:-

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?

Mental heuristics question

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

Mental heuristics question

 

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.

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”

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.