The Psychology of

Human Misjudgment- II

Introduction to framing

How would you frame requests?Availability - drop an anchor, use captivating vivid stories, use “man who syndrome”

Assume today is 27 March 2009 i.e. there are only five days left in the

financial year ending on 31 March 2009. One of your

friends has approached you to advice him on his

investments. He presents you with the following data

about his current portfolio:

In addition, your friend also tells you that during 2008-09, he has already realized short-term capital gains of Rs 27 lacs. He now needs Rs 73 lacs by selling part of his portfolio. Which

stocks should he sell?

To a man with a hammer everything looks like a nail

Bias # 2

Perceptual contrast

Two types of contrast effecthigh contrastlow contrast

Cialdini’s Sharon

“Dear Mother and Dad, Since I left for college I have been remiss in writing and I am sorry for my thoughtlessness in not having written before.“I will bring you up to date now, but before you read on, please sit down. You are not to read any further unless you are sitting down, okay?

“Well, then, I am getting along pretty well now. The skull fracture and the concussion I got when I jumped out the window of my dormitory when it caught on fire shortly after my arrival here is pretty well healed now...

“I only spent two weeks in the hospital and now I can see almost normally and only get those sick headaches once a day...

“Fortunately, the fire in the dormitory, and my jump, was witnessed by an attendant at the gas station near the dorm, and he was the one who called the Fire Department and the ambulance...

He also visited me in the hospital and since I had nowhere to live because of the burnt-out dormitory, he was kind enough to invite me to share his apartment with him. It's really a basement room, but it's kind of cute. He is a very fine boy, and we have fallen deeply in love and are planning to get married. We haven't set the exact date yet, but it will be before...

my pregnancy begins to show. Yes, Mother and Dad, I am pregnant. I know how much you are looking forward to being grandparents and I know you will welcome the baby and give it the same love and devotion and tender care you gave me when I was a child...

“The reason for the delay in our marriage is that my boyfriend has a minor infection which prevents us from passing our premarital blood tests and I carelessly caught it from him...

“I know that you will welcome him into our family with open arms. He is kind and, although not well educated, he is ambitious...

“Now that I have brought you up to date, I want to tell you that there was no dormitory fire, I did not have a concussion or skull fracture, I was not in the hospital, I am not pregnant, I am not engaged, I am not infected, and there is no boyfriend. “However, I am getting a “D” in American History and an “F” in Chemistry, and I want you to see those marks in their proper perspective. Your loving daughter, Sharon.”

What will happen if you put this in your mouth and then...

and then you put this in your mouth?

Dan Airely

Dan Airely

Decoy

Decoys in comparablesExample of 2nd most expensive wine on the menu - the most expensive is the decoy which is supposed to make the 2nd most expensive (and very profitable for the restaurant) wine look better than the cheaper ones and good value compared to the most expensive one.

Buying a Lamp

Buying a Car

In availability bias - it was about anchoring - u were anchoring to price of lamp and price of car and NOT anchoring to wealthhere its about contrast - high contrast - the Rs 1000 saving on a lamp looks BIG but SMALL in a car

$15$15$15$15 $15 $95 $95 $150

Experiments show that average wine sales increase substantially by having the $150 bottle listed right next to the $95 bottle. Moreover, the sales increase happens not because of a rise in sales of the $150 bottle but due to a rise in sales of the $95 bottle. The role of the $150 bottle is to act as a decoy to make the $95 bottle appear more desirable.The way to sell a lot of $800 shoes is to display some $1,200 shoes next to them...

Averaging down is a good idea but like most good ideas, if they are carried to the extreme, become bad ideas…

Blind averaging down can be injurious to your (financial) health.

Just because a stock has fallen 80%, doesn’t necessarily make it cheap and worthy of averaging down

Catching a

Falling Knife

Bling averaging down can cause grave harm if you do it with the wrong kind of stock.

Beware of Little Expenses for A Small Leak will Sink

a great ship

Here is another example…

Small things add up

When compared with a LARGE investment, They LOOK small, but they add up and become BIG.

How would the Buy-and Hold Strategy do?

How would the Buy-and Hold Strategy do?

tax-paying investorswill realize a far, far

greater sum from a single investment that

compounds internally at a given rate than from a

succession ofinvestments compounding at

the same rate.

Buy and Hold Investor gets the same performance with 88.85% as that of the market

timer with 100%.

Is a Rs 10 stock cheaper than a Rs 100 one?

Stock splits can’t make people richer?

How could exchanging a Rs 100 note for ten Rs 10 notes make you rich?

Evolution happens too slowly to be observed. Low contrast effect. Small changes tend to go un-noticed

Time lapse video:

http://www.youtube.com/watch?v=6B26asyGKDo

If you put a frog in boiling hot water, it will instantly jump out and escape

But if you put a frog in lukewarm water and slowly boil it, it will slowly boil to death!

While there is no truth to this story whatsoever, the human equivalent of the boiling frog is there in all of us...

Foot in the Door

Small and seemingly harmless initial commitments, set the stage for much larger subsequent commitments

Compliance rate: 17%

Followed by...

Compliance rate: 77%

Earlier Compliance Rate: 17%Invocation of Contrast Effect + Cognitive Dissonance

Followed by...

Petition to Keep California Beautiful

Compliance rate: 50%

Earliest Compliance Rate: 17%Compliance Rate with prior related but much smaller request: 77%

“Cognition, misled by tiny changes involving

low contrast, will often miss a trend that

is destiny.”

“Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny.”

Killing Me Softly...

Digital camera’s killed the photographic film business.But it did not happen in a day, or a month, or a quarter.

It was slow, painful (for films)….

Killing Me Softly...

Killing Me Softly...

“Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny.”

You’ve just got to acquire the skill to spot long-term trends - even if they are slow - indeed PARTICULARLY because they are slow because OTHERS who are victims of low contrast are going to MISS IT

Sometimes the light at the end of the tunnel is from an oncoming train!

Jerome S. Bruner and Mary C. Potter, “Interference in Visual Recognition,” Science, Vol.

144 (1964), pp. 424-25.

Pictures of common objects, coming slowly into focus, were viewed by adult observers. Recognition was delayed when subjects first viewed the pictures out of focus. The greater or more prolonged the initial blur, the slower the eventual recognition. Interference may be accounted for partly by the difficulty of rejecting incorrect hypotheses based on substandard cues.

You need to distance yourself from the noise...

Look what SAIL looked like in 2002-03.Stock was quoting at Rs 6.In 4 years it went to 150. How did this happen?

It did not happen in a day, or a week, or a month.It would have been missed by those who focus on short term

Long term value drivers?

Margin Improvement. How?1. Getting out of low margin business2. Getting into high margin business3. Pricing power4. Cost reductions not passed on to customers5. Scale economics

Efficiency Gains. How?1. Scale economics2. Supply chain management

Growth? How?1. Getting into high growth, profitable businesses.

De-growth? How?1. Getting out of low growth businesses

Balance sheet1. Asset sales2. Debt reduction3. Debt refinancing4. Debt restructuring

This is a fantastic description of markets from Ben Graham’s Security Analysis.

It tells you what you need to IGNORE and what you need to FOCUS on

There are only a FEW things out there that are important. All the rest is NOISE.

So you need to figure out in life how to get rid of the noise and focus on the music in there somewhere...

framing

How would you frame requests using perceptual contrast?

High contrastlow contrast

Bias # 3

Deprival Super

Reaction

Text

Rules:

1. Highest bidder wins

2. 2nd highest bidder also has to pay his bid price to the auctioneer.

How did this very smart businessman end up overpaying for these assets in auctions?

Winners’ Curse… - what models explain this lollapalooza outcome?

Deprival Super Reaction Syndrome

(DSRS)

give example of two friends sharing a cab to the airport. both miss their flights - one by just 5 min and one by 30 min - who will face more regret

If you deprive me, I’ll have a

super reaction!

The human equivalent of the dog deprived of his bone is there in all of us

“The quantity of a man’s pleasure from a ten-dollar gain does not exactly match the quantity

of his displeasure from a ten-dollar loss.”

Losses have about 2.5 times the impact of gains of the same magnitude.

Choose between:

85% chance of winning $100 (the gamble)

or

sure gain of $85 (the sure thing)

Choose between:

85% chance of losing $100 (the gamble)

or

sure loss of $85 (the sure thing)

People tend to accept more risk to avoid losses than to obtain equivalent gains

Funny video depicting man experiencing misery when his cash pile disappears...

People feel considerably more pain after incurring a financial loss than they feel pleasure after achieving an equivalent gain

The Psychology of the Near Miss

DSRS also takes place when you almost have something you love and you “lose it” [“near-misses”]

Two friends sharing a cab to the airport. both miss their flights - one by just 5 min and one by 30 min - who will face more regret

“You own a small casino in Las Vegas. It has fifty standard slot machines which are identical in appearance. “Moreover, they have exactly the same payout ratios. The probability of hitting a jackpot is identical in all of them and they amount of money won in case of a jackpot is also the same. “But there’s one slot machine in this group that, no matter where you put it among the fifty, produces 25% more winnings for the casino at the end of the every day. “What is different about that heavy winning slot machine?

Traffic Crossing videoWhat SHOULD you do when the light turns yellow?What do yo ACTUALLY do?What happens to people’s risk assessment abilities when are about to “lose something?”Well, they become gamblers…

In a game of skill, like shooting, a near miss gives useful feedback and encourages the player by indicating that success may be within reach

What will happen if slot machines and instant lotteries are contrived to ensure a higher frequency of near misses than would be expected by chance alone?

Near misses in random situations fool people into “trying harder” next time

361204 965304 865305

If the winning lottery number is 865304, the owner of which ticket is likely to “try harder” next time?

You’ve got to learn how to deal with losses in life (personal and professional). One way to do that is to invert. How much happier would you have been because your date came five minutes EARLY? And if you would not have been GREATLY pleased, then why are you GREATLY PISSED because he/she is five minutes LATE?

desperate fears after losing a lot of money induces

people to take enormous risks with the rest of

their money - Gambler’s ruin

Many gamblers stake everything thats left of their bankroll on the riskiest of the bets - which obviously offer the highest payouts - just to “get back in the game”

Why can’t people afford to write off their losses?

Countdown video

People go crazy when they see countdownsThey overpay for things they don’t need and shouldn't have...

“The sale is about to end”

Countdown effectVolumes rise during the last few minutes of trading. Why?

“I am going to lose this opportunity to buy (sell) this stock because it would open higher (lower) tomorrow morning. Therefore I am going to behave like the man who when approaching a traffic crossing sees the light turn yellow from green…”

Fear of losing something possessed, or something not possessed but almost possessed.

Its processed in amygdala - part of the innermost brain.

Basic Instinct - part of our genome

“Run away when you sense danger” had a huge survival advantage when your ancestors lived in the caves. But modern world is different….

Basic Instinct

Neuroeconomics shows that financial losses and mortal danger are processed in the same part of the brain: Amygdala

Game: 3 types of subjects were chosen to play a game: normal brains, damaged amygdalas, brains damaged in areas other than amygdala (controls). Each player was given a starting capital of $20 and was then offered a choice to play a game or not. The game involved a coin toss. To play the game one had to invest $1

Heads, you lose $1Tails, you win $2.5

Total number of rounds: 20

What would you do?

You’d play all the rounds. Odds is heavily loaded - you may lose a few rounds but overall result in 20 rounds is expected to in your favor.

Damaged amygdalas played 84% of the rounds

Normals played 63%

Controls played 61%

Why???

Damaged amygdalas did much better than the other two

groups!

This does not mean that to be rational you have to experience brain damage :-)

Fear of losing our MTM profits makes us sell out of

good decisions too early.

The stupidity of “you can’t go broke taking a profit.”

Reptilian or lizard brain

I use the “lizard brain” to describe the older,

more emotional parts of the human brain. The

lizard brain is the most important driver of

market irrationality, and it is completely

ignored by traditional finance and economics.

We are built to solve the problems faced by our ancestors. Because modern industrialized society differs systematically from the world of our ancestors, we tend to get into trouble.

Our brains, like our bodies, reflect the world of our ancestors. In particular, our lizard brains are pattern-seeking, backward-looking systems that allowed us to forage successfully for food and repeat successful behaviors.This system helped our ancestors survive and reproduce, but financial markets punish such backward-looking decisions.

Terrance Odean

http://faculty.haas.berkeley.edu/odean/Papers%20current%20versions/AreInvestorsReluctant.pdfanalyzed the trading records of ten thousand accounts at a large national discount brokerage firm over a seven-year period beginning in 1987 and ending in 1993. Among other findings, his gargantuan research effort high-lighted a pair of remarkable facts. First, investors were in fact more likely to sell stocks that had risen in price rather than those that had fallen.

Professor Odean has published another study that confirms his earlier finding that trading is dangerous to most people’s pocketbook. As with the previous work, this second study (coauthored with Professor Brad Barber) examined the brokerage accounts of thousands of individual investors. The goal was to look at the difference between men and women, and it has the provocative title of “Boys Will Be Boys. In what way were boys being boys in this study? Professors Barber and Odean found that men in this study were worse investors than women. Per each dollar invested, men earned significantly less money than women. In investigating the reasons for the gender difference, it turned out that men traded 45% more frequently than women. Every trade is costly so all other things being equal, the more an investor trades, the less money at the end of the year. All that extra trading definitely cost men. How about the actual stock selection? Were men or women better at picking winning stocks? Professors Odean and Barber found that men and women are equally bad at picking stocks. On average, every trade cost the investors money as compared with not trading. Men did worse simply because they traded more. The study concludes, “Men lower their returns more than women because they trade more, not because their security selection is worse.”

men in this study were worse investors than women. Per each dollar invested, men earned

significantly less money than women. In investigating the reasons for the gender difference, it turned out that men traded

45% more frequently than women.

This study examined the brokerage accounts of thousands of individual investors. The goal was to look at the difference between men and women, and it has the provocative title of “Boys Will Be Boys. In what way were boys being boys in this study? Professors Barber and Odean found that men in this study were worse investors than women. Per each dollar invested, men earned significantly less money than women. In investigating the reasons for the gender difference, it turned out that men traded 45% more frequently than women. Every trade is costly so all other things being equal, the more an investor trades, the less money at the end of the year. All that extra trading definitely cost men. How about the actual stock selection? Were men or women better at picking winning stocks? Professors Odean and Barber found that men and women are equally bad at picking stocks. On average, every trade cost the investors money as compared with not trading. Men did worse simply because they traded more. The study concludes, “Men lower their returns more than women because they trade more, not because their security selection is worse.”

“Being overly sensitive to loss

leads people to opt for a certain gain

over one that offers a high possibility of

a larger gain.”- Daniel Kahneman

Stocks Vs. Bonds

In real life that usually translates into a preference for fixed-income investments over stocks. A guaranteed 6 percent or 7 percent annual return from Uncle Sam may seem a lot more appealing than the “chance” to earn 11 percent or more a year in stocks. But as we’ll see later on, the dangers of the stock market may not be as important as the ravages of inflation. So to the extent that you opt for “safe” investments—such as bonds, annuities, and other fixed-income or life insurance products—over riskier but generally higher-paying ones, your loss aversion may be costing you a lot of money.

framing

How would you frame requests DSRS

Regular bulbs vs. CFL

Thank you