In 2016 I bought a health insurance policy.
Cover: 7 lakh; Premium: 7k.
I was already covered under group insurance offered by my employer. This health insurance was (and is) free, i.e. premiums are paid by my employer and not deducted from my salary.
I am relatively young, with no history of premature heart disease, diabetes or cancer in the family.
So why did I buy choose to buy more health insurance and pay 7k?
Enter Prospect theory to argue my stupidity.
Prospect theory states that losing a million dollars shrinks your heart more than making a million dollars swells your heart with happy feelings. In other words, our emotional brain sucks at math.
Economists, in their assumed role as social scientists, can be wrong about a lot of things. Their theory of utility assumes that people are stoic philosophers and would treat gaining and losing million dollars all the same as long as they can maximize profits in the end.
News flash for Economists: humans beings are not 100% rational.
Ask any historian, he will tell you about the Gold Rush, Tulip Mania and the World Wars.
Prospect theory is more realistic in its understanding of the human condition than the idea of utility developed in the echo chambers of academia.
Prospect Theory states that we base our decisions – our expectations of outcomes – on weighted probabilities. Basically, we are biased.
I bought more health insurance because I was – used to be – a heavy smoker.
I suffered from a disproportionate fear of getting lung cancer, although the odds of me dying from a car crash or being gored by a stray bull are just as high, maybe higher.
I suffered from a bias that behavioral economists call loss aversion, so I bought more insurance, to save myself from a health emergency, that may lead in turn to a financial catastrophe.
Actually it was the financial catastrophe I feared more than cancer. I trust the advances of medical science, but I don’t trust private hospitals, the job market, or expect social support in old age.
Middle-class Indians grow up in scarcity. Our minds our moulded to recognize the worst catastrophes as one possible outcome of our decisions.
A catastrophe like most middle class Indians fear the Stock Market will bring to their finances because of one such probability called Gafla
Bias: Market is Gafla
In India, Gafla is a way of life. Ipso facto the stock markets should be Gafla as well.
To understand this mindset, one needs to witness a bubble burst in their generation.
A speculative bubble is a social epidemic whose contagion is mediated by price movements. – Robert Shiller, 2013 Econ Nobel Prize
Indian Markets reached social epidemic levels in 1992, when the quantum of retail involvement in India reached its peak. The panwallah was passing the latest stock tip instead of the latest political gossip. Like most bubbles – there was a trigger – economic liberalization ushered by Dr Manmohan Singh had unleashed animal spirits in a repressed society.
Stock mania reached such a high that the BJP – then a nascent party – predicted the crash caused by Mehta would bring down the Narsimha Rao government. That’s how pervasive investing in stocks was, one upon a time.
Then came the crash.
The result was mass disbelief of the kind that impacts the psyche of generations. A desi version of the Great Depression.
Investor psyche has still not recovered from the trauma of the Harshad Mehta scam. Entire generations have opted out of market participation because of Harshad Mehta. No drawing room discussion on Stocks goes without Harshad Mehta.
Harshad Mehta and 2008 form powerful anchoring bias in the minds of young people even today. They form the representations of risk in their mind when they anticipate returns from investing in stocks. The excess returns aren’t enough to compensate for the risks involved, ergo, the convexity of loss is even more skewed in the Indian context than in the general human psychology because of our fear of Gafla
But Father Time, true to form, has waited for no-one. All the while there has been a reform in the way the Indian markets operate. Regulatory oversight, democratization of information, better disclosure standards and the spawning of online investor communities and support networks.
Foreign Institutions and Funds have taken full advantage of the value unlocking in the Indian Economy while the general Indian taxpayer has sat out from benefitting from the earnings made by Indian companies. The stock market has been a tragedy, but not of the kind you would expect. History rhymes, but does not repeat.
Bias: Stocks are a Lottery Ticket to Riches
On the other end of the cynicism spectrum lie the Lottery Chasers. These are people who have higher risk appetite than the average person. Their education does not gulf the gap between their aspirations and the risks involved in their decision making but they believe luck will take them past the bridge, or at least hope so.
They are the reason why so many IPOs get overpriced and give poor returns over the long term. The Lottery Seeking crowd are egged on to subscribe to them by FOMO, or the fear of missing out. They crowd out IPOs – and in many cases Midcaps, which then get overpriced quickly. This set of investors is not informed enough to do valuations, or time their exit, and often end up losing money.
This is the crowd that buys based on stock tips, whatsapp forwards, and is prone to eschew diversification in the favor of concentrating their wealth into a few stocks – giving their portfolio the quality of a Lottery ticket.
These are the lambs to the slaughter, or rats that follow pied-pipers like Harshad Mehta.
The Market for them is like a Red Room on the Deep Web, where you can watch them get tortured in High Definition video – FOR FREE.
Bias: Past Returns predict Future Returns
When thinking about allocating money to a stock, investors mentally represent the stock by the distribution of its past returns and then evaluate this distribution in the way described by prospect theory.
These are the investments professionals who fall into the trap of basing decisions on backward looking Wealth Creation studies (e.g. yearly reports by Motilal Oswal). These are the retail buyers inescapably in love with compounders like Asian Paints, Infosys and HDFC. I have a friend (a hobbyist like me) who put 60% of his net worth in Larsen and Toubro in 2015.
Unfortunately for him past returns are not a reliable indicator of future returns, but many risk averse investors adopt past performance as a highly weighted probability in their decisions on capital allocation – because to the risk averse human mind, past performance is the most reliable guarantee against future risk.
Bias: Sunk Costs; or Everybody Hurts, Sometime
If you entered the market in early 2008, no amount of factor analysis or expertise would have saved you from the ass whooping that followed. On the contrary, if you gave a baboon the ability to take delivery of stocks in 2012, he would be touted as a stock picking genius by the financial media – or at least inexorably in his own mind.
It can be hard to time the markets but how long will you stay associated with the market? It depends on your experience with the market.
A tide will lift all boats and a storm will sink all boats. When did you take your boat out to sea?
You can either love the markets, or loathe them based on macro-economic factors out of your control.
A past flatmate of mine from a top business school – a fundamental investor with a CFA charter – had this irrevocable experience with losing money in a few stocks.
Because of his experience, he vowed off the market for all time. In his mind the loss was too painful to relive and the sunk cost was a deterrent to any future attempts at utility maximization via equity.
Sunk Costs hurt. Many average down their losers because they hurt so much.
It hurts when a portfolio stock falls in major correction – but trying to bring down your average buying price by buying even more is a recipe for ruin.
A rational investor would cut his losers fast and let his winners run.
But What is Rationality Anyway?
The field of behavioral finance would not exist if the markets were efficient.
Fama got a Nobel for positing market efficiency, Sharpe for CAPM and yet Behavioral finance is a legit discipline. No one has an answer, and therein lies the beauty of the markets.
So far I have come across no investor free of bias in their decision making.
Bias can be a blessing if balanced with experience and sagacity. George Soros attributes much of his success to intuition, and purely factor or momentum based quant investing can give subpar results.
Make Bold Moves but be aware of your biases.
Wait in time, or take the jump.
Disclaimer: I am not a SEBI Registered analyst. I am writing to organize my thoughts and in good faith to share with the investor community. I do not offer Buy or Sell advice on this blog and none of my writing should be construed as a recommendation to Buy or Sell. I declare that I am not invested in any of the companies mentioned in this post. For more information please see the About section.