Ego investing

Ego investing
FE Investor Bureau
Posted online: Aug 03, 2009 at 0006 hrs

Gamblers and mathematicians maybe familiar with what is known as the Martingale probability theory or the Martingale betting strategy and the theory is simple and works on the assumption that a gambler with infinite wealth will never loose. This assumption leads many to take disproportionate risks.

All one needs to do is say in simple games of heads or tails or any other gamble, is to keep doubling his bet after every loss. This will ensure that as and when you do win a bet, you will not only recover all your losses but also make a profit of the original sum you invested. Say for example you bet Rs. 1,000 on heads and loose. Then you double your bet to Rs. 2,000 and loose again. Then you continue playing and double your bet to Rs. 4,000 and loose yet again. Now, you bet yet again, and this time you bet Rs. 8,000.

Having, this time finally won you get Rs. 8,000 and have hence, not only recovered the loss of Rs. 7,00 you had previously incurred, but also make a profit of Rs. 1,000 (the original sum bet).

No, this is not a fool proof or sure shot method to always making money in a casino nor is it a gambling tip. The interesting point to be noted for those who practice this theory is that one’s risk aversion pattern contradicts financial prudence and relies more on emotions.

It is for this reason itself that gamblers often keep on playing even after loosing all the money they decided they could afford to loose, simply in the hope of winning. The reason he/she does not get up and leave the casino is not because they cannot afford that loss sustained, but simply the fact that their ego has been bruised and hurt, and no one likes to end up losing. Hence, in the hope of turning things around one keeps at it till, more often then not they are completely wiped out.

This kind of emotional gambling or making of financial decisions is seen in two extremes, one is when you’re losing and one is when you’re winning heavily. If human financial stupidity were to be depicted in a bell curve, one would see it having a very heavy tail and a very small head. The tail represents the losers which are far greater in number than the winners, and, both have ended up there due to their irrational decisions. In investing they are often termed as greed and fear, with greed making most people follow the madness of the mob, in the hope of making some profits, while fear is what often causes people to try and convert a loss into a profit no matter how slim the odds, often ending up with a bigger loss than needed. "Markets invariably move to undervalued and overvalued extremes because human nature falls victim to greed and/or fear" said William Gross, in his book, “Everything You've Heard About Investing is Wrong!”

Prospect theory

This is a theory that believes people value gains and losses differently and, as such, will base decisions on perceived gains rather than perceived losses. Hence, if a person were given two choices, one expressed in terms of possible gains and the other in possible losses, even though both amount to the same, people would choose the former. It is also known as "loss-aversion theory".

Tversky and Kahneman originally described, "Prospect Theory" in 1979. They found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They found that individuals are much more distressed by prospective losses than they are happy by equivalent gains.

Some economists have concluded that investors typically consider the loss of Rs.1,000 twice as painful as the pleasure received from a gain of the same amount. They also found that individuals will respond differently to equivalent situations depending on whether it is presented in the context of losses or gains. Researchers have also found that people are willing to take more risks to avoid losses than to realize gains. Faced with sure gain, most investors are risk-averse, but faced with sure loss, investors become risk-takers.



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Here is an example from Tversky and Kahneman's 1979 article. Kahneman and Tversky presented groups of subjects with a number of problems. One group of subjects was presented with this problem:

In addition to whatever you own, you have been given $1,000. You are now asked to choose between:

a. A sure gain of $500

b. A 50% change to gain $1,000 and a 50% chance to gain nothing.

Another group of subjects was presented with another problem.

In addition to whatever you own, you have been given $2,000. You are now asked to choose between:

a. A sure loss of $500

b. A 50% chance to lose $1,000 and a 50% chance to lose nothing.

In the first group 84% chose A. In the second group 69% chose (b). The two problems are identical in terms of net cash to the subject, however the phrasing of the question causes the problems to be interpreted differently.



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Peter L Bernstein in “Against the Gods states that the evidence "reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty."

Prospect theory also explains why investors hold onto losing stocks: people often take more risks to avoid losses than to realize gains. For this reason, investors willingly remain in a risky stock position, hoping the price will bounce back. The loss-aversion theory points to another reason why investors might choose to hold their losers and sell their winners: they may believe that today's losers may soon outperform today's winners. Investors often make the mistake of chasing market action by investing in stocks or funds which garner the most attention. Research shows that money flows into high-performance mutual funds more rapidly than money flows out from funds that are underperforming.

Regret theory

People tend to feel sorrow and grief after having made an error in judgment. Investors deciding whether to sell a security are typically emotionally affected by whether the security was bought for more or less than the current price. One theory is that investors avoid selling stocks that have gone down in order to avoid the pain and regret of having made a bad investment. The embarrassment of having to report the loss to the accountants, family, friends and others may also contribute to the tendency not to sell losing investments.

Regret, theory deals with the emotional reaction people experience after realising they've made an error in judgment. Faced with the prospect of selling a stock, investors become emotionally affected by the price at which they purchased the stock. Some researchers theorise that investors follow the crowd to avoid the possibility of feeling regret in the event that their decisions prove to be incorrect. Many investors find it easier to buy a popular stock and rationalise it going down since everyone else owned it and thought so highly of it. Buying a stock with a bad image is harder to rationalise if it goes down. Additionally, many believe that money managers and advisors favor well known and popular companies because they are less likely to be fired if they underperform.

What investors should really ask themselves when contemplating selling a stock is, “If this stock was already liquidated, would I but it again?” And, if the answer is “no” then it is time to sell the stock.

Perceiving risk

As per prospect theory, investors really want to know is not just how much an asset deviates from its expected outcome, but how bad things can get. Value at risk (VaR) attempts to provide an answer to this question. The idea behind VaR is to quantify how bad a loss on an investment could be with a given level of confidence over a defined period of time. For example, the following statement would be an example of VaR: "With about a 95% level of confidence, the most you stand to lose on this Rs10,000 investment over a two-year time horizon is Rs 2,000." The confidence level is a probability statement based on the statistical characteristics of the investment and the shape of its distribution curve, it is also known as standard deviation in statistics. However, this is not necessarily the worse case scenario as after all, 95% confidence allows that 5% of the time results may be much worse than what VaR calculates.

Mental accounting

John Allen Paulos states in his book Innumeracy, "There is a strong general tendency to filter out the bad and the failed and to focus on the good and the successful.”

Humans have a tendency to place particular events into mental compartments, and the difference between these compartments sometimes impacts our behavior more than the events themselves. Say, for example, you aim to catch a show at the local theater, and tickets are Rs. 200. When you get there you realize you've lost the Rs. 200 in your wallet. Do you buy a Rs. 200 worth ticket for the show anyway? Behaviour finance has found that roughly 88% of people in this situation would do so. Now, let's say you paid for the Rs 200 ticket in advance. When you arrive at the door, you realise your ticket is at home. Would you pay Rs 200 to purchase another? Only 40% of respondents would buy another. Notice, however, that in both scenarios you're spending Rs 400. An investing example of mental accounting is best illustrated by the hesitation to sell an investment that once had monstrous gains and now has a modest gain. During an economic boom and bull market, people get accustomed to healthy paper gains. When the market correction deflates investor's net worth, they're more hesitant to sell at the smaller profit margin. They create mental compartments for the gains they once had, causing them to wait for the return of that gainful period.

Finally

Many researchers believe that the study of psychology and other social sciences can shed considerable light on the efficiency of financial markets as well as explain many stock market anomalies, market bubbles, and crashes. As an example, some believe that the out performance of value investing results from investor's irrational overconfidence in exciting growth companies and from the fact that investors generate pleasure and pride from owning growth stocks. Many researchers (not all) believe that these human flaws are consistent, predictable, and can be exploited for profit.

The theory that most overtly opposes behavioural finance is the efficient market hypothesis (EMH), associated with Eugene Fama & Ken French (MIT). Their theory that market prices efficiently incorporate all available information depends on the premise that investors are rational. EMH proponents argue that events like those dealt with in behavioural finance are just short-term anomalies, or chance results, and that over the long term these anomalies disappear with a return to market efficiency.

Thus, there may not be enough evidence to suggest that market efficiency should be abandoned since empirical evidence shows that markets tend to correct themselves over the long term. In his book "Against the Gods: The Remarkable Story of Risk", Peter Bernste tells us. "While it is important to understand that the market doesn't work the way classical models think - there is a lot of evidence of herding, the behavioral finance concept of investors irrationally following the same course of action - but I don't know what you can do with that information to manage money. I remain unconvinced anyone is consistently making money out of it."

However, whether these behavioural finance theories can be used to manage your money effectively and economically is still a question mark. That said, investors can be their own worst enemies.

http://www.financialexpress.com/printer/news/497155/