Emotional Investing

INSTEAD OF BEING SMART, FOCUS ON AVOIDING FOOLISH BEHAVIOR

Try Counting Backwards from 30

Case 1

82 24 48 86 61 11 – What is the pattern in these numbers?

Case 2

A bat and a ball together cost $1.10 in total. The bat costs a dollar more thanthe ball. How much does the ball cost?

REFLEXIVE BRAIN

Effortless

Fast

Automatic

Prone To Errors

Also called System 1

Default System – go to circuits

Intuitive processing

Example: Smell, Taste , feeling

(Driving a Car) ?

REFLECTIVE BRAIN

Effortful

Reasoned

Slow and Logical

Less Prone to Errors

Also called System 2

Backup Machinery – “uh-oh” circuits

Analytical thinking

Example: Solving 345*235^2

What should I get my wife for our anniversary

What should we use Reflexive or Reflective ?

Reflexive – Gauge the management behavior. (++)

Reflective – This is the best quant model built, Ah! It failed only in 2008 (--)

Dose of both are needed

Greed Thought of finding a multibaggar is super exciting.

Bigger the potential Gain ; greedier you will feel ; you will stop thinking about the odds Ask what is the chance this stock will earn me the super returns ?

Anticipation is processed reflexively while probability is processed reflectively

Fun Fact – “Buy the Rumor; Sell the news” is based on anticipation

Control Greed – see is the stock passes your checklist If you feel the urge to trade; go play a online poker game

Question – What is the expectation when we buy a Stock

Predictions Over the past thirty years the analysts' estimate of what companies would earn in the next quarter

has been wrong by an average of 41%.

Markets are Random; We look for patterns within this Randomness!

We tend to predict based on shorter term memory and recent events.

Follies with Predictions - Markets have never hit an upper circuit :P – Really !!!I have always made money in this stock

Fun Fact – “The human compulsion to make predictions about the unpredictable originates in the dopamine centers” ; Dopamine is released, when we have some unexpected profits

Question – Should we believe Analysts?

Confidence Overconfidence makes us take more risks;

Familiar Stocks – brings home over confidence [ these can be risky ]

Hurts to say – I don’t know, hurts our self esteem

Fun FactOnly 37% of corporate managers believe that mergers create value for the buyers, and a paltry 21% think that mergers meet the strategic goals set by acquirers. However, when it comes to their own mergers and acquisitions, 58% of experienced managers say they have created value, and 51% believe they have met their strategic targets.

Question – Do you say you know it all? If yes – then it means you stop asking questions

Risk Risk is constantly changing – A small change to any one of these can turn you into a bull / bear

Past experiences Alone or part of a group How familiar are you with that situation Your mood

ExampleIn a small village, there has been a type of flu which has potential to cause death. Population of village is 600; There are few programs which could help in this crisis.

Set 1Program A – will save 200 peopleProgram B – 1/3 probability of saving 600 people and 2/3 probability that nobody will be saved

Set 2Program C – 400 people will dieProgram D - 1/3 probability nobody will die, 2/3 probability that 600 people will die

Risk Risk can change based on how we frame our questions as well

Positive risk framing – Program A – will save 200 peopleNo emotional cost, as we save lives

Negative Risk Framing - Program D - 1/3 probability nobody will die, 2/3 probability that 600 people will dieHere our brain needs to work more, as we see death; we see little chance that people are

saved and emotional side makes us choose D

When we become part of a group (herd) we are inclined to ask less questions

Profit/Loss on your previous investment can also determine how risky the next bet is

Question – What creates the frames inside our brains? Interaction between feeling and thinking; We look for the easiest way to reach to a decision – lowest emotional cost and least mental effort.

Fear“Airplane Crash” – how risky do you think this is ?

The more vivid and easily imaginable is the risk; scarier it feels. Emotions shooing away our Analytical Power

When we feel in charge; Risk seems lower than they truly are

Fear of Losing Lasts for Long – We have two or 3 consecutive losses, we will tend to stop betting or even freeze if the impact of loss was large.

I go along with the herd not because I consciously choose to do so, but because it hurts not to.

Surprise

It's impossible to predict corporate earnings to the penny. Infosys – expectations were not met, stock down. Negative surprise

Unexpected surprise’s – have higher impact.

The future will most brutally surprise those who are the most certain they understand it

Regret Regret - aftermath of a nasty surprise.

Surprise – oh, oops! Moment ; Regret – comes after slow thinking, “why or how could I”

When do we regret Huge loss - I wish I had not done this or I knew I should have invested in X Opportunity missed – I told you that was going up or I should have sold then

The investments we own tend to seem better to us than those we don't own. Difficulty to Sell ?

Non Fun Fact - Why is it so hard to sell? "When you sell a loser," explains psychologist Daniel Kahneman, "you don't just take a financial loss; you take a psychological loss from admitting you made a mistake. You are punishing yourself when you sell." On the other hand,, "Selling a winner is a form of rewarding yourself.“

When we make a large investing mistake, your insula (area of a brain) generates much the same response to your own action as it would to a pile of rotting fish or a bag of garbage that's been sitting in the sun. You move away from the stench. (move away from taking Risks)

Question – Portfolio Paralysis ?

Regret Investors are disgusted with their own blunders, their natural aversion to taking a loss finally breaks

Panic Sells

How do we control Regret Face it and Fess up – “Ask - Do we have a loss or a lesson?” Profit booking Strategy – choose a plan. ( Few have been discussed in the Group ) Get Help from others to help you pull the trigger – Banks loan reevaluated by another person Balance your portfolio – asset allocation helps

Checklist Mcap to Sales < 1

Good ROC > 20

Operations Cash Flow positive for at least 3 out of 5 years

Debt to Equity < 0.5

Will there be growth in sales and profit margins remain stable ( difficult for me )

Technicals – see if the trend is up, moving averages 200,50, 20 check

Questions which can control our emotions• Do I understand this company's products or services?

• Did I read the company's financial statements, including footnotes?• Reading the AR, can cool you off, if you think the stock is a hot one

 • Last time, made money on this stock – will you make money in the stock

again?

• Ask these questions when you see prices going down… this should cool you off a bit !!

• Other than the price, what else has changed?• Are my original reasons to invest still valid?• If I liked this investment enough to buy it at a much higher price, shouldn't

I like it even more now that the price is lower?• What other evidence do I need to evaluate in order to tell whether this is

really bad news?

Some Quotes which I likeThe fault, dear Brutus, is not in our stars, but in ourselves

Market is a rapist, only when you don’t have our clothes on!

Thank You

SourceBook Your Money & Your Mind – Jason Zweig Prof Bakshi articles.