Dealing with behavioral biases

Parag Parikh
Human thought processes are an amalgam of experience, intuition and rationality. Our actions are usually based on the belief that we know what is good for us. However, many times those actions are based on impulses which may actually be detrimental to us in the long run. Also, since the feedback mechanism is often not instantaneous, we bear the consequences of our actions much later. By that time it may be too late to remedy the situation. This behavioral tendency is visible in every aspect of our lives be it education, health, money, relationships etc.

While academics steadfastly cling to the ephemeral notion of “Rational Man”, there is an irrefutable and growing body of evidence contradicting this. If humans were truly rational, then all of them would have behaved in a very similar manner. For instance, the traditional regimented route to success is : Finish your schooling, go to a “reputed” college, pursue a “safe” degree and get a “good’ job, which until recently meant either a doctor, engineer or lawyer.

However, over the years, an increasing number of students have chosen to go on the road less travelled and guided by their heart, have chosen off-beat courses such as wild-life photography, linguistics, etc. At the outset, virtually no one knows whether they will be successful or not. However, that does not deter them from putting in their best effort. My point is, even in a relatively unadventurous field such as formal education, many a time, the heart rules the head.

Coming back to the core subject of this article, whenever clients visit advisors, they expect us to solve all their financial problems and want us to assist them in attaining all their financial aspirations. However, I have observed that they display several cognitive and emotional behavioral biases while interacting with us. Here are a few of them:

Optimism Bias:
Many a time, clients visit us after they have experienced some kind of financial trouble. It could be related to debt burden, the tendency to over-spend, a job loss etc. At that point they are overly optimistic about our ability to provide quick-fix solutions and immediately get them back on track. Often they fail to comprehend that it takes a joint effort on the part of both, client and advisor, to emerge out of the rut.

Representative Bias:

Many times clients compare us to their family doctor and expect that we will provide them with the equivalent of tablets which will help them recover in a few days. While, it is true that there are some parallels between the two professions, we are more adept at providing solutions which will help you in the long-term rather than the short-term. In other words, feedback mechanisms are often not instant, in our case. On a lighter note, I think it would be better if they compared us with to dieticians rather than cosmetic surgeons.

Sunk Cost Fallacy:

Clients persist with products which are unsuitable for them, simply because they have paid for them. Investment oriented insurance policies are good examples. The policies that they currently own may provide a low life cover and may be opaque & difficult to understand, Yet they are reluctant to surrender them, despite us pointing out better options. This is because they have already paid the premium for the past few years. Consequently, they are unwilling to bear any surrender-related losses, even if rationally they should be agreeing with our contention that in the long run it would be costlier to continue with the policy.

Confirmation Bias:

Often, certain long-standing beliefs have already ossified in clients’ minds when they approach us and it is difficult to suggest something which is contrary to these. For instance, if we suggest increasing equity exposure to an avowed debt investor, he may diligently point out all recent instances when the equity market has crashed. At the same time, he will not accord any weightage to the stellar cumulative performance of the stockmarket over the past two decades or so.

In other words, he will cling on to examples which fortify his belief that stocks are risky and conveniently ignore the ones which disprove this belief. To such people I cite several examples of companies reneging on their debt obligations.

Bandwagon Effect:

Everyone is more bothered about what the others are investing in rather than researching which product suits them the most. For instance, over the past one year, when Fixed Maturity Plans (FMPs) were in vogue, many of our clients were keen on opting for one year FMPs merely because some acquaintance or the other had done so.

This included clients who needed to utilise the same money within the next six months and for whom the illiquidity of the FMP was a big negative. It took a monumental effort to make them jettison this idea and convince them to park their capital in short term debt funds.

While there are many more such biases, the moot point is that while dealing with humans (and especially on a touchy subject like their finances), advisors must treat irrationality as “par-for-the-course” and not be surprised at anything that confronts them. This is more art than science. That is where experienced advisors score over the rookies who merely go by what their courseware states.

 

Envy: An (Un) necessary evil

Warren Buffett has apparently said in jest that out of the seven deadly sins, envy is the worst….because at least we enjoy while committing the other six sins. In case of envy it is only pain and no pleasure.

Despite this, I notice that envy is widespread in our society. Here are a two instances:

  • A client of mine met me last week. I noticed that he was not his usual chirpy self. When I inquired about the reason for his despondency, he explained that he was perturbed to note that while his Portfolio Management Scheme (PMS) Account with our firm had given him a return of 12% over the past year (no mean feat, considering the the broad indices were actually down by 17%). It perplexed me that instead of being ecstatic he was downcast but I soon knew why. Apparently, his friend had invested in another PMS account which also invested in Gold Exchange Traded Funds. Hence his friend had earned a return of 21% on his investment, which apparently gave him bragging rights over my client.
  • Every year once the annual bonus is distributed among colleagues at my company, I always notice a few glum faces. In most cases, they are not glum because they feel shortchanged, but are dejected because a few of their colleagues have received slightly more than them.

How do we deal with this debilitating feeling? While I do not profess to be a psychologist or psychiatrist, here are a few options that work for me. Continue reading

S&P downgrade : Caution or an Opportunity?

– Parag Parikh

The current state of stock markets the world over have unsettled the minds of the investors. In such situations we are prone to behave irrationally. Equanimity is important and to maintain that it is important to analyze the situation.

We tend to make decisions based on the currently, readily available information vividly displayed. Open any newspaper or flip through a business channel, or go to a party, there is only one talk of the US being downgraded by the S&P. Why? Because of the high fiscal deficit and the high amount of debt. Is this really new? Did not the world know about it? So why the reaction? Well it is because of the availability bias. Today the downgrading is the centre of attraction. Go back a couple of months in the memory lane. The 2G scam, the Anna Hazare fast, the CWC games scandal. When they were the centre of attraction the newspapers, the TV channels concentrated only on those news. Although none of the matters have still been sorted out, how much reporting does one see? Over the next week the euphoria on the down grade will die down. Continue reading

Margin Trading in Real Estate…..

By Parag Parikh | pparikh@ppfas.com

We have created and nurtured a society where insanity works. Take the recent advertisements by builders selling flats with just 10% upfront down payment. The balance is to be paid on possession. It sounds so good and consumer centric but is it really so?

What an invention. Enter Margin trading in real estate. What is Margin trading? In short it is buying beyond your means. It is very popular in stock markets. At present real estate prices have doubled in the last year and the builders are only building flats. Investors are buying and waiting for the greater fool theory to work. They expect that someone will still buy it at a higher rate from them. However that is not happening. With so many residential premises coming in the market you need someone to buy it so the investors exit and make money. The consumer that is the real user of such flats is existent but he does not have the capacity and money to buy it. There is big latent demand for housing because people need houses but it does not mean that they will be able to afford the current prices. It is beyond most peoples’ means. How do you raise money to complete such projects and pay off high interest debts when there are no genuine buyers at such high prices?

This is how it works. The flat prices are at record highs. They have doubled in just a year fueled by investor demand. The flats are offered at just a down payment of 10%. The balance has to be paid on possession. However the fine print does specify certain conditions. One of the conditions is that one cannot get out of the deal and there is a heavy penalty if one chooses to do so. This is only for serious buyers thus goes the argument. The brokers who are able to get buyers are offered a brokerage of 2% and above packaged with gifts of Mercedes cars and other luxuries. That’s real hard selling. Real estate prices are currently highly inflated and even a correction of just 10% wipes away the buyer’s capital.

So the upfront 10% is just an incentive for one to get into the debt trap. When the time of the possession comes who knows the prevailing real estate prices. If they are lower than today imagine the plight of the buyer. Not only has his asset lost value but how will he be able to get a bank to finance him? The bank finance will come at the rate prevailing at that time. The loss in the value of the asset will wipe out his capital and he will have to opt for the debt trap. Imagine the interest one would pay when one does not have a bargaining power. And of course the high maintenance charges of these new luxurious buildings will be an added stress on the already burdened home buyer.

The lure of the new and such quick fix schemes need to be avoided at any cost. You can’t be margin trading in real estate especially when there is no exchange to let you know the fair market price of the real estate. It is run and regulated by the builders lobby itself. Surely these are signs of a big real estate bubble and crony capitalism allows such ponzi schemes to flourish.

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This first appeared as an article in Business Standard dt. October 20, 2010.

If consumers are irrational it makes sense for companies to cater to that belief rather than eradicate it

You purchase a brand new mobile for Rs. 10000. The first year you have a free warranty. The salesman offers you a warranty for the second year for Rs. 500. You fall for the bait and buy the second year warranty. What are the chances of your mobile conking off in the second year. May be 1% looking at the track record of all the mobile phones in the last few years. So your warranty is worth only Rs.100. However you believe that the salesman is your best advisor and pay Rs.500 for something which is worth only Rs.100.
However you are in an efficient market and competition will ensure that market forces will drive out these warranties from the market or the warranty prices come down to Rs.100 as more companies start giving warranties. This is how a rational mind will think. Well you are dead wrong if you assume the above to happen.Warranty is a product no one should buy. If humans realized that they would be paying Rs.500 for Rs.100 worth of insurance, they would not buy the insurance. But if they do not realize this, markets cannot and will not reveal the situation.
Competition will not bring the prices down. The salesman plays an important role as a friend and an advisor to sell you something worth Rs.100 for Rs.500. It is difficult for third parties to enter the market efficiently as how can they make money by persuading you not to buy.
When many people are still afraid of flying it was common to see airline flight insurance sold at airports at exorbitant prices. There were no booths on airports selling people advice not to buy such insurance.

Now when the stock markets are up one must be careful. You have brokers, investment bankers, mutual funds, banks in the guise of your best  friends and advisers trying to sell you dreams. When the markets are up more mutual funds and more IPO’s hit the markets. They want to benefit from irrational behavior of investors. However there will be no firms asking you not to be swayed as they cannot benefit from it.

We are in a market where firms compete for the same consumers. Some sell cigarettes and some help you to quit smoking. Some sell fast food while others advise you for diet. If all are rational human beings (econs) then there is no argument which competing interest will win. However the problem is that consumers are humans and make irrational decisions leading to bad choices. Here is how firms benefit out of their irrational behavior. In stock markets we have opposing interests like day traders v/s long term investors and stock tips v/s value investors. Irrational investors add to the chaos making it easy for firms to benefit from their irrationality. Your business news channel has become your stock advisor, the banks salesman is your financial advisor,and your friendly neighbor is your portfolio manager.

At present stock markets are going through great volatility. It is important that investors keep their cool and behave rationally. There are hawks waiting to make money out of you. Remember there are no short cuts in life. Ponder on the following questions: Why do IPO’s not come in bear markets?  Why do we not get stocks tips daily on our mobile in bear markets? Why don’t FIIs buy in bear markets when the prices are low? Why do experts predict markets higher when the stocks are going up? How does one know that the Sensex will touch 25000?

My friend you are in a bull market. You are more likely to turn irrational and make big money mistakes. That’s the reason you got to be cool and not be carried away by the noise of the markets.