fbpx
the butterfly effect cover

The Butterfly Effect: This Theory Can Change Your Life

It has been said that something as small as the flutter of a butterfly’s wing can cause a typhoon halfway around the world.

One of the greatest surprises in the scientific world is the chaos theory or butterfly effect which are events in our lives that are both non-linear and unpredictable. While science traditionally deals with outcomes that can be predicted and calculated to a certain extent like chemical reactions or the force of gravity, there are often many instances that are nearly impossible to predict like natural disasters, stock prices or the weather.

The first step to overcoming this unpredictability is to understand the chaotic nature of the world we live in. Identifying the elements that cause changes in stock price or the weather can help us steer our thinking in a certain direction. Finally, we need to remember that our eco, social and economic systems are all interconnected and taking negative actions on any of these systems can result in detrimental consequences.

The Butterfly Effect

The butterfly effect describes the phenomenon that a small event can have very large consequences.

This chain reaction is perfectly described in the movie ‘Pay it forward’ where a small boy, Trevor, creates a plan of kindness for a school project.  A recipient of a kind favor carries forward this favor to three other people. As the movie goes on we see this circle of people who do favors become bigger and bigger and ultimately affects the lives of many people in the community. One random act kindness started by a small boy resulted in a very large impact, changing everyone’s lives for the better.

While the movie represents a glass half full situation, the butterfly effect can be negative as well. For example, as much as meteorologists try to predict natural disasters, there have been tsunamis and typhoons that are inexplicable.

It is important to remember that the butterfly effect is not a small event that can have a large impact which can eventually be driven to the desired end but it is in fact a small event in a complex universe that can either have a very large impact or no impact at all. It is virtually impossible for us to identify or predict which one will occur.

The invention of the butterfly effect

In popular culture, the butterfly effect is used to describe the explain the inexplicable. How one small event can have a magnanimous effect on a completely unrelated event. This theory was first discovered by an MIT meteorology professor, Edward Lorenz who came across the phenomenon while conducting some weather-related research.

In 1963, Lorenz was conducting research on weather patterns and entered numbers into a program that was based on 12 variables such as wind, speed, and temperature. These values would be depicted on a graph that would rise and fall depending on the weather pattern. Lorenz ran a stimulation similar to the one he ran previously and the results he saw surprised him.

The variables were drastically different from what he saw previously when he ran the same stimuli. This would forever change the way his program produced weather patterns. He said “the numbers I had typed into the computer were not exactly the original ones. They were rounded versions I had first given to the printer. The initial errors caused by rounding out the values were the cause: they constantly grew until they controlled the solution. Nowadays, we would call this chaos.”

This unexpected change in the value of the variables based on the same stimuli led Lorenz to the powerful insight that the smallest of changes could have large unpredictable effects. He later termed this the butterfly effect saying that a butterfly could flap its wings in one part of the world and it could cause a typhoon in a completely different place. This led him to the conclusion that even with knowledge of primary conditions, the future was virtually impossible to predict.

Lorenz presented his findings in a paper titled ‘Deterministic Nonperiodic Flow’ which is considered one of the greatest achievements of twentieth-century physics. He said that there are small variables that can have profound impacts on the same body or system in the future. The strength of the impact is however unpredictable. Weather is a variable that is often hard to predict.

How the butterfly effect has impacted reality?

There are many references in real life (also represented in popular culture) where a small event has resulted in a large consequence- the butterfly effect. Here are a few ways the butterfly effect has shaped modern history.

The bombing of Hiroshima and Nagasaki

The nuclear bombs dropped on Hiroshima and Nagasaki is remembered as one of the most significant events in the war that changed the course of history and won Korea their independence. A little research into the war will tell you that the U.S intended to bomb the Japanese city of Kuroko.

However, on the fateful day, bad weather conditions prevented the U.S from doing this. The fighter planes flew over the city three times and eventually gave up due to the lack of visibility. The military personnel then made the split second decision to bomb Nagasaki instead. This bombing, as has been documented in history, had a magnanimous effect on the war and changed the course of history. If the weather conditions in Kuroko had been better, it might have resulted in a completely different outcome.

The Chernobyl accident

In Soviet Ukraine, 1986, a catastrophic accident occurred at a Chernobyl nuclear plant. The disaster was a result of design flaws in the reactor and the arrangement of the nuclear core that was not in accordance with the manual. This nuclear accident is said to have released more radiation that the bombings of Hiroshima and Nagasaki. Numerous people were evacuated and it also resulted in deaths and birth defects.

However, the accident could have been much worse, after the initial release of radiation three workers volunteered to go turn off the underground valve which is said to have eventually killed them. This was a brave and heroic act because had they not turned off the valve when they did, more than half of Europe would have been destroyed and inhabitable (the butterfly effect). The Chernobyl accident has had numerous long-term effects and many believe it is the cause of global warming. Countries today are slow to adopt nuclear power as an energy source.

Closing Thoughts

While the human race thrives on control and predictability, the butterfly effect shows us that we, in fact, cannot predict the future. The complex universe around us is chaotic and vulnerable to even the smallest of changes. As humans, we can only identify catalysts that react to these conditions. However, if we try to control or predict outcomes, more often than not, it will result in failure.

Finally, always remember what the butterfly effect actually teaches us- “Everything that you do matters”. 

mental models cover

What are Mental Models? And Why Should You Care?

“Like a pane of glass framing and subtly, distorting our vision, mental models determine what we see”- Peter Senge.

Have you ever stopped to question your perception of the world around you? Have you asked yourself: ‘Is the way you view something really how it is in the real world?’ More often than not the answer is NO because our current perception of the world serves us quite well. In fact, we barely question it at all because that’s how limited our view of the world really is.

But have you stopped to think, that in a world so large and complex, there’s more to life than what we see and recognize? For instance, there are so many ways we can look at a problem and at the same time, there’s always more than one solution to the same problem. As humans, it can be a challenge to analyze and understand the vast amounts of information present in this world which is why we need mental models.

What are Mental models?

In its most basic form, a mental model is an image or model a person has of the world around them, that is, how they perceive their surroundings. This view varies by each being and it helps shape their behavior and how they react to the different situations they are presented with. However, many people only have one mental model and try to use it to solve a variety of problems.

In 1994, during a speech to business school students, Charlie Munger summarized this with a quote ‘To the man with one hammer, every problem looks like a nail.’ Possessing just one mental model is equal to having a very narrow perception of the world, which, essentially, is not a great way to operate in the ever-changing world we live in today.

There are numerous mental models that vary by discipline and developing multiple models can help you think more rationally. Here are three mental models used in business, psychology, and economics to help you get started:

Confirmation Bias (Psychology)

Confirmation bias is the tendency of humans to favor the information that aligns with their values and beliefs and ignore everything else that doesn’t fit into our perceptions. A great example would be the Buzzfeed personality quizzes like ‘What Harry Potter character are you?’ Before you even take the quiz, your confirmation bias or the way you perceive yourself has already decided that its Hermione Granger of course!

You have already confirmed the answer to the quiz based on the traits of the character and how they match up to your own personality. This confirmation bias can be applied to our everyday lives as well. Very often we find ourselves making purchases based on confirmation bias and later finding a rational reason to justify the purchase.

A simple way to overcome confirmation bias is to analyze your reasons for buying something, be it a stock or a car- you need to look at both sides of the coin. Make a list of the pros and cons along with the reasons why you want to make the purchase and why you might want to sell it in the future.

Also read: 5 Common Behavioral Biases That Every Investor Should Know.

Moral Hazard (Economics)

A moral hazard is when one party or entity makes a decision on how much risk to take while another party suffers the consequences if things go south. Moral hazard can be dangerous as it can cause the party that does not bear any costs to practice reckless and impetuous behavior.

While in theory, moral hazard can seem unlikely, as society has come to believe that the person making the decision has to bear its associated costs as well, this concept is very much prevalent in the insurance and medical industries. For example, a person taking out a policy on fire insurance has no motivation to protect their home from the risk of fire as they know that any damage caused by fire will be the responsibility of the insurance company. Likewise, in the medical industry, doctors are more likely to prescribe expensive treatment or surgery to their patients if they are covered by medical insurance.

Another great example of moral hazard is during the 2008 financial crisis, where banks and other financial institutions were close to bankruptcy due to their recklessness and poor decision-making. In the end, it was the government that had to intervene and prevent these companies from going under using tax-payers money to bail them out. The consequences of the poor deal-making on the side of the banks was borne by the government.

Network Effect (Business)

A network effect is when the utility you receive from using a product increases as more people use the same product and service and is a common mental model used in business.

A great example is the different types of social media we use today. When Twitter was first introduced, not many people knew exactly what it was and hence not many accounts existed. At this time your motivation to create a Twitter account is not too high as there aren’t many people you can interact with on the platform. But as Twitter gained popularity and more people started using it, you were more inclined to join as the utility you receive from it is now much greater than it was before. The network effect has made Twitter a major source of news today.

The network effect is prevalent in e-commerce sites as well. With websites like Amazon, the value of the platform increases as more people purchase goods and services and leave positive reviews. This encourages more people to use the platform, thus increasing revenue for the company. The network effect is a mental model used in many businesses and is a great way for companies to gain a competitive advantage in the market they operate in.

Resources to read:

Conclusion

The mental models listed above are just three in a long list of models that exist. Mental models can vary by discipline and it can often be a challenge for humans to learn and understand all the models that exist.

However, it is important to master the primary models to gain the wisdom of the world. Charlie Munger refers to these as the ‘Big Ideas.’ Mental models can help you think ‘outside the box’ and widen your perspectives on the world. You can use them to make wise and intelligent decisions!

How to learn faster- The Feynman Technique cover

How to learn faster- The Feynman Technique!

As the world around us evolves, we seek to constantly learn and absorb new information every day. Learning new skills and concepts is exciting and can expand your views on the world as you know it, making you a better student and human being. As Benjamin Franklin said ‘An investment in knowledge pays the best interest’.

But there is no denying that learning all this new information can sometimes get tedious and monotonous, there’s only so much knowledge that your mind can take in at any given time. However, thanks to scientific research, there is a method you can use to make the process of studying easier and efficient while increasing your ability to learn- the Feynman Technique. But before we discuss this technique, let me first introduce Richard Feynman to you.

Who was Richard Feynman?

richard feynman

Theoretical physicist and Noble laureate Richard Feynman was born in 1918 in Queens, New York. From a very young age, Feynman quickly took to science and engineering and had a laboratory in his parent’s home where he built various electronic devices.

By a young age, he was self-taught in various subjects such as algebra, trigonometry, and integrals. Eventually, Feynman went on to study at MIT and later Princeton for his Ph.d, where he made numerous contributions in the field of Physics. Some of his accomplishments include:

  • He contributed research papers on the theory of light and matter which earned him a joint Noble Prize in 1965.
  • When the Space Shuttle Challenger disaster occurred, Feynman helped research scientists understand the cause for the crash and the risks involved in flying the shuttle
  • He made a major contribution to quantum physics through the Feynman Diagram. The diagram aimed to visualize the interactions between elementary particles such as electrons and photons.

In addition to the major contributions to Physics, Feynman had the ability to apply his learnings to other fields such as mathematics and biology. He has the ability to comprehend and explain information on a variety of subjects that earned him the title ‘The Great Explainer.’ His vast knowledge led him to give numerous guest lectures at universities such as Cal Tech and UCLA. Many people, including Bill Gates, enjoyed his lectures due to his ability to break down and simplify complex scientific principles.

The Feynman Technique

Say you want to have a good understanding of a really hard concept in a discipline of your choice. There’s a chance that you may find the theory hard to comprehend as the crux of the matter is lost in translation aka with all the business jargon. The ability to understand and communicate these complex ideas in a simple way is what the Feynman technique addresses.

This method was developed by Richard Feynman when he was a student at Princeton. He kept a notebook of concepts and theories that he did not understand and spent time breaking down each process and understanding its parts individually, while looking for contradictory details in the theory. The technique essentially comprises of four parts as follows:

1. Pick the concept or theory you wish to learn

The first step in the Feynman technique is to identify what concept or theory you want to learn and list out everything that you know about the topic in a notebook. This could be any concept, under any discipline.

For instance, if you want to learn more about the game theory, your first step would be to write down all the existing (even limited) information that you have on the topic. Any new information about the theory from various other sources can be added to the notebook. For the game theory, you can start by writing down the definition of the concept and any information about the theory that you may have come across (for example prisoner’s dilemma…).

2. Teach or explain the concept in your own words to someone else

As you approach the second step in the Feynman technique, you would have gathered plenty of information on the subject (in this case game theory). Read through the information you have written down and try to understand the concept as best you can because this step involves teaching it to someone else.

But before you explain the concept, analyze the information in parts, this can also mean re-writing some of the information in your own words to have a better understanding. When explaining the concept, think of it as explaining to a child who has no background in what the concept is about. Hence, you need to use simple words (no jargon) and keep the information concise and to the point- children have a low attention span.

3. Identify any areas in your explanation that you can improve on

Now that you’ve explained the concept to someone else, it is likely that you will find a few areas in the theory that you can learn and improve on. So it’s back to the books to do additional research on certain concepts and breaking the data down further until you understand them completely. The goal is to make the information as simple as possible because that’s what the Feynman technique is all about.

4. Restructure the information and use examples as needed

The information you collected from various sources in the first step of the Feynman technique is essentially a puzzle that you need to solve.

Once you have identified the gaps in your information in step 3, your next move is to fill in these gaps to complete the puzzle. Think of your concept as a story and pretend that you are narrating it to a friend or co-worker.

When you say the information out loud, it can help identify the missing pieces and form new thought processes. Alternatively, you can use examples to simplify your learnings and add an element of creativity.

the feynman technique safal niveshak

(Image credits: Safal Niveshak)

Also read:

Conclusion

The Feynman technique aims to simplify complex learnings by breaking them down into smaller parts.

The technique can help you understand pretty much any concept or theory known to man and it helped Feynman amass large amounts of knowledge at a very young age. The trick is to break down any concept into a form so simple, that even a child would be able to comprehend the information. Albert Einstein famously said ‘if you can’t explain it simply, you don’t understand it well enough.’

Prisoner's dilemma cover

What is the Prisoner’s Dilemma?

The Prisoner’s Dilemma is a popular two-person game of strategic thinking that is analyzed as part of game theory. It demonstrates how rational individuals are unlikely to co-operate even when it is in their best interests to do so.

The game uses the example of two prisoners being interrogated and how they respond and change their strategy over time depending on the situation.

However, before we discuss the prisoner’s dilemma, let’s first understand what is game theory.

What is Game Theory?

Game theory is the use of mathematical models to identify the reasons for conflict and cooperation between individuals. It helps us understand why an individual makes a certain decision and how their decision affects others.

The application of this theory in non-gaming scenarios is called gamification. The three main branches discussed below are closely related to game theory:

— Decision theory: This can be described as a game of an individual against nature. People’s decisions are based on their personal preferences and beliefs. The decision among risky alternatives is described by the maximization of the utility function. In turn, the utility function is dependent on various factor but mostly the level of money income.

— General equilibrium theory: This is a branch of game theory that deals with a large group of individuals such as consumers and producers. It is used in macroeconomic analysis such as the tax policy, to analyze the stock market or to fix exchange rates.

— Mechanism theory- While the game theory follows the rules of the game, the mechanism theory discusses the consequences associated with each of the rules. The questions addressed include wage agreements, spreading risk while maximizing revenue.

The Prisoner’s Dilemma

Game theory can be described as two players playing a game and listing out the choices and alternatives available to each player.

A famous example of the game theory is the Prisoner’s Dilemma where two individuals who are partners in crime are caught by the police and interrogated in two separate rooms and are given the chance to confess.

Since each prisoner has two possible options (either to confess or don’t confess i.e. remain silent), there are four outcomes to the game as represented in the matrix below:

the prisoner's dilemma 1-min Rules of the game:

  • If both players confess to the crime, they both get sent to jail but they will get a shorter sentence if one of the players is ratted out by his partner in crime.
  • If one player confesses while the other one remains silent, the one who remains silent gets a long severe prison sentence while the one who confesses goes free.
  • However, if both players don’t confess, they both get a shorter prison sentence than if they were to both confess.

 The options in the game (both risks and rewards) are represented as utility numbers.

In the table above, the positive numbers are favorable outcomes while the negative numbers are negative outcomes. However, one outcome is better than the other if the total value is greater. So -5 is better than -10.

In the table above, there are four outcomes, if both players confess, they are blamed equally for the crime (-5,-5). But if one player provides information on the other player in exchange for going free, the individual receives a utility of 3 units. But the other prisoner who does not confess and is sent to prison has a low utility of -10.

The last option is both prisoners don’t confess and sent to prison on reduced terms which results in a very low utility of -1.

Analyzing the Prisoner’s Dilemma

Once the various outcomes in the game are described, the next step is to analyze how the players are likely to respond. Economists make two assumptions when it comes to analyzing this game.

The first is that both players are aware of the total payoffs for themselves and the other player. The second assumption is that both players are looking to satisfy their personal gain from the game.

To analyze the outcome of the game, we can look at the most dominant strategies- this is the most optimal solution for one player, despite the response of the other player. Using the table above, confessing to the crime would be the dominant strategy for both players.

  • It is better for player 1 to confess if player 2 confesses as well because a utility of -5 is better than -10.
  • Player 1 should confess even if player 2 remains silent as 3 is better than -1.
  • Similarly, it would be better for player 2 to confess if player 1 confesses as -5 is more optimal than -10.
  • Player 2 should confess if player 1 remains silent as a utility of 3 is better than -1.

For player 1 and 2, confessing to the crime would be the equilibrium solution to the game.

the prisoner's dilemma 2-min

The Nash Equilibrium

The Nash Equilibrium was developed by mathematician John Nash and it shows the best response strategies in any situation. It is an outcome where one player’s strategy is the best response to the other player’s strategy and vice versa.

As per the outcomes in the table above, if player 1 confesses, it is in player 2’s best interest to confess as well as -5 is better than -10. And if player 1 doesn’t confess, player 2 should still confess as a utility of 3 is better than -1 and vice versa. The best strategies are highlighted in green in the table above.

Note: In case you enjoy visuals, here’s a simplified video on Prisoner’s dilemma:

Also read:

Why has this game become so popular among economists?

There are many reasons why the Prisoner’s Dilemma has become an important tool for economists in developing numerous economic theories.

The strategies to ‘confess’ or ‘not confess’ is used to identify if certain economic theories ‘contribute to the common good’ or ‘behave selfishly’. This is also known as the public good problem.

For example, if the government decides to construct a road, the construction of the road is beneficial to everyone. But, it would be better for the individual if the private sector and not the government built the road. When government spending does not benefit the individuals in the economy, it is known as an externality.

For two competing firms, the outcomes can be ‘set a high price’ or ‘set a low price’. For both companies, it would be beneficial to set high prices to earn higher revenue. But for each individual company, it would be more optimal if they set a low price while their competition set a higher price.

The game also shows how a rational individual should behave. As shown by the dominant strategy, it is best for both player to confess but in terms of utility confessing only results in -5 unit of versus the -1 unit they would receive if they did not confess. The conflict between the individual and the common goal is the basis of many economic theories.

The Prisoner’s Dilemma is an important tool used by economists when making decisions on economic theories and public spending. The payoff matrix can be applied to our everyday lives to find the most optimal solution in any situation.

5 Psychology Traps that Investors Need to Avoid

5 Psychology Traps that Investors Need to Avoid

Benjamin Graham once said that “an investor’s chief problem and even his worst enemy- is likely to be himself.” It is a well-known fact that the human brain is a wonder that is capable of numerous mathematical, problem-solving and communication skills that is unparalleled with any other living species.

However, when it comes to investing, humans have been known to make terrible decisions and often fail to learn from their own mistakes. They go through a ‘roller-coaster of emotions’ as shown below.

Investment process – Roller coaster of emotions

(Image Source: Credit Suisse)

While the human mind is incredibly unique, people still fall victim to the investor traps that can have serious consequences in the financial markets. This has led to the emergence of behavioural finance, a new field that aims to shed light on investors’ behaviour in financial markets.

This post discusses the most common psychological traps investors need to overcome to increase their chances of earning high returns.

5 Psychology Traps that Investors Need to Avoid:

Anchoring Bias

Anchoring Bias occurs when people rely too much on a reference point in the past when making decisions for the future- that is they are ‘anchored’ to the past. This bias can cause a lot of problems for investors and is an important concept in behavioural finance.

For example, if you had a favourable return on a stock when you first invested in it, your perception on the future returns of stock is positive even when there may be clear signs indicating that the stock might take a dive. It is important to remember that financial markets are very unpredictable so you need to remain flexible and seek professional advice when not-sure of making considerable investment decisions.

Herding

Also known as the mob mentality, is a tactic that was passed on from our ancestors and believes that there is strength in numbers. Unfortunately, this is not always the best strategy in the financial market as following the crowd is not always the right move.

Ironically, this herding mentality among investors is the major reason for ‘bubbles’ in the financial markets. Investors often ‘herd’ to secure their reputation and base their decisions on past trends or on investors who have had success with the same stock in the past. However, people are quick to dump stock when a company receives bad press or go into a buying frenzy when the stock does well.

As an investor, you should perform your own analysis and research on every investment decision and avoid the temptation to follow the majority.

Loss Aversion

Loss Aversion is when people go to great lengths to avoid losses because the pain of a loss is twice as impactful as the pleasure received from an investment gain. To put in simple terms, losing one dollar is twice as painful as earning one dollar.

Loss Aversion- How it can ruin your investments

As emotional beings, we often make decisions to avoid a loss, this could involve investors pulling their money out of the market when there is a dip which leads to a greater cash accumulation or to avoid losses after a market correction investors decide to hold their assets in the form of cash.

However, this perceived security of exiting the market when it is unstable only leads to a larger amount of cash circulated in the economy which results in the inflation. During the 2007 financial crisis, there was $943B worth of cash increases in the US economy.

Investors can avoid the loss aversion trap by speaking to a financial advisor to learn how to cut their losses and optimize their portfolio for higher returns.

Superiority trap

Confidence is an asset when it comes to investing in the stock market, but over-confidence or narcissism can lead to an investor’s downfall. Many investors, especially those who are well educated and have a good understanding of finance and in the functioning of the stock market often believe they know more than an independent financial advisor.

It is important to remember that the financial market is a complex system made of many different elements and cannot be outwitted by a single person. Many investors in the past have lost large sums of money simply because they have fallen prey to the mentality of overconfidence and refused to heed anyone’s advice. Overconfidence is the most dangerous form of carelessness.

Confirmation bias

Confirmation trap is when investors seek out information that validates their opinions and ignores any theories that refute it.

When investing in a particular stock that believe will result in favourable returns, an investor will filter out any information that goes against their belief. They will continue to seek the advice of people who gave them bad advice and make the same mistakes. This results in biased decision-making as investors tend to look at only one side of the coin.

For instance, an investor will continue to hold on to a stock that is decreasing in value simply because someone else is doing the same. The investors help validate each other’s reasons for holding on to the investment, -this, however, will not work in the long-term as both investors may end up in a loss. Investors should seek out new perspectives on a stock and conduct an unbiased analysis of their investment.

Also read:

How can an investor overcome these psychological traps?

The human mind is very complex and there are many factors both internal and external that can affect the decisions we make. The pressures we face in society make it easy to feed into temptation and fall prey to the psychological traps listed above. Being overconfident, seeking validation from others and finding comfort in other people who are in the same boat as you are just some of the reasons that can have an impact on the investment decisions we make.

Nobody is perfect and it is only human to fall into a psychological trap. The best way to mitigate these effects is to stay open to new information and think practically about how the investment will affect you as an individual. You should also seek the advice of industry experts to ensure that your investment decisions are based on well-researched information that can help you make unbiased decisions.

How Sunk Cost Fallacy Can Affect Your Investment Decisions cover

What is Sunk Cost Fallacy? And how it Can Affect Your Decisions?

Have you ever been in a situation where you went to watch a movie in the theatre, however, it turned out to be terrible? What did you do next? Did you walked out of the theater or continued watching it till the end because you were afraid that you have already paid for the ticket? If you choose the latter, you have fallen for the sunk cost fallacy.

In this post, we are going to discuss what exactly is a sunk cost fallacy and how it can affect your investment decisions. But first, let us understand what are sunk costs.

What are sunk costs?

Sunk costs are those irrevocable costs which have already been occurred and cannot be retrieved. Here, the costs can be in term of your money, time or any other resource.

For example- Let’s suppose that you bought a brand new machine. However, after using it for three months, you realize that the machine is not actually working as you desired. And obviously, the return period of the machine has surpassed. Here, even if you sell the machine, you will get a depreciated value compared to what you originally bought. This cost is called the sunk cost.

In general, people should not consider sunk costs while making their decisions as these costs are independent of any happenings in the future. However, humans are emotional being and unlike robots, we do not always make rational decisions.

Examples of Sunk Cost Fallacy

Sunk cost fallacy, also known as Concorde fallacy, is an emotional situation where the individuals take sunk costs into consideration while making the decisions.

We have already discussed the example of watching the entire movie (even if it is terrible) just because you, as a consumer, won’t get back the money of your ticket. This is a classic example of sunk cost fallacy.

Another example can be when you eat foods that you do not like because you have already bought that food and cannot revoke that sunk cost. Similarly, overeating after ordering foods in restaurants because food has been already ordered is also an example of sunk cost fallacy.

Further, a typical example of the same fallacy is when you keep attending the miserable classes of your college (that you do not enjoy) because you have already invested a lot of time in that course and also have paid the tuition fee. Besides, salaries, loan payments etc are also considered as sunk costs as you cannot prevent these costs.

A quick point to mention here is that not all past costs are sunk costs. For example, let’s suppose you bought a shoe and you didn’t like it after reaching home. However, as the shoe is still in the return-period of 30 days, here, you can return the shoe and get back your purchase price. This is not a case of ‘sunk cost’.

Sunk Cost Dilemma

Sunk cost dilemma is an emotional difficulty to decide whether to continue with the project/deal where you have already spend a lot of money and time (i.e. sunk cost) or to quit because the desired result has not been achieved or because the project has an obscure future.

Here, the dilemma is that the person cannot easily walk away from the project as he has already spent a lot of time and energy. On the other hand, continuously pouring more money, time and resources in the project also do not seem a good idea because the outcomes are uncertain. This dilemma of deciding whether to proceed further or to quit is called sunk cost dilemma.

For example- Let’s say you started a business and invested $200,000 over the last three years. However, you haven’t achieved any wanted result so far. Moreover, you cannot see the business working out in the future. Here, the dilemma is ‘what to do next?’. Should you bear the losses and move on, or should you invest more resources in that uncertain business?

Another common example of sunk cost dilemma can be a bad marriage. Here, the couples find it difficult to decide whether to save themselves (and their spouse) by splitting up when they are sure that the things are not going to work out. Or should they hold on to the marriage just because they have already spend a lot of time together and breaking up will make them look bad?

Sunk cost dilemma in Investing

Even investors are common people and they face the sunk cost dilemma while making their investment decisions.

For example, let’s say that an investor bought a stock at Rs 100. Later, the price of that stock starts declining. In order to minimize the losses, the investor averages out the purchase price by buying more stocks when the price kept falling (also known as Rupee cost averaging). Here, the dilemma happens when the stock keeps underperforming for a stretched period of time. Here, the investors are uncertain whether they should book the loss by selling their stocks, or should they continue averaging out with the hope that they may recover the losses in the future.

Another example of the sunk cost dilemma is people buying/selling aggressively in risky stocks once they have incurred a few major losses in the past to ‘break even’ those losses. However, the losses have already been incurred and investing in risky stocks to cover those losses won’t do any good to such investors. The better approach would be to choose those stocks that can give the best possible returns in the future, not the imaginary aggressive returns that they expect to match up the sunk cost.

As an intelligent investor, people should ‘not’ consider the sunk costs while making their decision. However, this is rarely the case.

Also read:

Closing Thoughts

It is no denying the fact that nobody likes losing and hence the past losses can influence the future decisions made by the individuals. However, one must not consider sunk costs while making their investment decisions.

As sunk costs cannot be changed (recovered), a rational person should ignore them while making their judgments. Here, if you want to proceed, first you should logically assess whether the project/deal is profitable for the future. If not, then discontinue the project. In other words, try to forecast the future and react accordingly.

Anyways, a few methods of solving the sunk cost dilemma is by opting for incremental wins over the big ones, increasing your options (not just to completely quit or go all in) and in the terminal case, cutting your losses. When stuck in this dilemma, try to make minimum losses by looking at the mitigating options.

Monte Carlo Simulation Cover

Monte Carlo Simulation -How can it help investors?

We face an element of risk in almost every decision we make which often leaves us feeling uncertain and ambiguous. Although we have unparalleled access to information, we can never predict the future. A method that can help ease this risk is the Monte Carlo simulation that allows you to see all the possible outcomes of a decision and its associated risk. It can help you, as an investor, to make better decisions at uncertain times.

Background

The Monte Carlo simulation was developed in the 1940s by Stanislaw Ullam, a brilliant Polish-American mathematician who was in charge of the Manhattan Project (R&D for WWII nuclear weapons). While recovering from a brain surgery Stanislaw spent many hours playing solitaire. He was soon drawn to trying to devise the game through the distribution of cards and predict the probability of winning.

Stanislaw’s analysis of trying to predict the outcomes led him to develop the Monte Carlo simulation. It was named after the glamorous gambling casinos of Monaco, France.

What is the Monte Carlo Simulation?

The Monte Carlo approach is a computer-based method that uses statistical sampling to build a model of a possible range of results (a probability distribution) for those factors that have an element of uncertainty.

The results for the uncertain elements are calculated over and over using a set of random values at each time. The values entered as samples into the simulation as input ate chosen at random from the probability of income distribution. These sample sets are called iterations. The simulation produces a distribution of possible outcomes and these outcomes are recorded.

The Monte Carlo simulation is used by many different sectors and industries from project management to energy and engineering. But it is especially applicable to the finance and business sectors due to its emphasis on random variables. The simulation can be used to calculate the probability that the costs of a certain project will exceed its budget and the probability that the price of an asset will go up or down.

In addition to this, the model can be used to determine the investment default risk and assess the performance of derivatives such as options.

Why should we use the Monte Carlo Simulation?

Simply put, the Monte Carlo simulation helps you make better decisions. It helps predict future outcomes based on different scenarios. The technique used in the simulation allows us to measure the risk in quantitative analysis. In addition to providing the outcomes in a given scenario, it lets us know the likelihood of each outcome occurring.

In terms of investing, the Monte Carlo simulation lets us identify all the risks associated with a particular investment. It gives us a range of outcomes so it can show you outcomes for conservative investments and incredibly risky ones. There is also a middle ground for the portfolio which is the outcome of a neutral investment and is particularly useful to investors who want to assess the risk of options.

How is the Monte Carlo Simulation useful to investors?

The Monte Carlo simulation helps investors assess their portfolios and make investment decisions. Modern technology has now made it easy to perform a Monte Carlo simulation with the just a few clicks. The investor needs to enter a relevant time period between 1-25 years along with a downside floor constraint or an upper target value.

The simulator then generates 10,000 possible outcomes by playing out each simulated version in the future from the lowest to the highest risk based on values entered. However, it is important to remember that the simulator does not take into consideration real-world events such as crashes or unexpected events. Reality can differ from the simulator but it is still a powerful tool in understanding the trade-off between risk and the upside.

There are many websites that can help you perform a Monte Carlo simulation such as Vanguard that offers a ‘Retirement Nest Egg Calculator’. Vanguard uses the Monte Carlo simulation to provide the possible outcomes of a retirement portfolio. It takes into account your balance sheet, spending, and asset allocation and tries to determine the probability that your investment revenue will last the duration of your retirement.

Vanguard Monte Carlo Simulation Retirement Nest Egg Calculator

(Image Credits: Vanguard)

Another great website is Personal Capital that also uses the Monte Carlo simulation to assess portfolios. The tool calculates the standard deviation and annual returns on the portfolio based on set targets. The result provides you with three market scenarios, the best possible case, the worst possible case and midpoint between the two. The tool aims to show how a diversified portfolio can be catastrophic when there is a bad market.

Disadvantages of the Monte Carlo simulation

Like all things, the Monte Carlo simulation has its shortcomings as well because no one can predict the future. The simulations are particularly disadvantageous during a bear market. This is because the outcomes are based on constant volatility and can create a false sense of security for the investors. In reality, however, stock markets are very unpredictable and the Monte Carlo simulation does not hold good for these scenarios.

Moreover, the simulation is unable to factor in the behavioral aspect of the stock market. The Monte Carlo simulation could not predict accurate outcomes during the volatile stock markets of 2008. Therefore the simulations only show an approximation of the true value and can sometimes show very large variances.

Also read: The Ultimate Guide to Walter Schloss Investing

Conclusion

The Monte Carlo simulation is used by many investors to gauge the performance of their investments so they can make more informed decisions.

While you cannot trust the outcomes of the simulation with complete certainty, they do provide a viable way to understand the trade-off between risk and investment. It is a great tool for advisors when assessing the potential risks associated with the client’s portfolio. By changing the investment horizon and the upper and lower targets of the simulation, you can have a better understanding of how you can affect and change the outcome of your future investments.

stock market cycle cover

The Stock Market Cycle: 4 Stages That Every Trader Should Know!

From the changing seasons to the different stages of our lives, cycles exist all around us. These cycles are often influenced by numerous factors at each stage. Likewise, cycles also affect the movements of stocks in the market. Understanding how these movements work can help a trader identify new trading opportunities and lower their risk.

In this post, we are going to discuss the four stock market cycle stages that every trader should know. Let’s get started.

Stages in the Stock Market Cycle

The movement of prices in the stock market can often seem random and hard to follow. Prices may go up on certain days, and down on others. To an average person, these shifts are often confusing and the prices can resemble a casino game.

The reality, however, is that the stock market cycles move in similar ways and go through the same phases. Once an investor understands the phases, the markets will not seem so random anymore. The trader can recognize each phase and change their style of trading accordingly. There are four phases in the stock market cycle as follows:

four stages of stock market cycle

(Image Credits: Investopedia)

1. The Accumulation Phase

accumulation phase

(Image credits: Investopedia)

This phase of the stock market can apply to an individual stock or the market as a whole. As the name suggests this phase does not have a clear trend and is a period of agglomeration. The stock tends to trends at a range as traders accumulate their shares before the market ‘breaks out’. It is also known as the basing period because the accumulation phase comes after a downward trend but precedes an uptrend.

The moving average does not provide a clear indicator at this point as the market is not following a particular trend. The longer the accumulation phase the stronger the break out in the market when the stocks start to trend.

How to trade:

The accumulation phase may last a few weeks or a few months. So use this time to study the market and anticipate the right time to enter. The price range during this period is small and not particularly advantageous for day traders. It is advisable not to make large trades at this time until a market trend is confirmed. A current event in the economy can take stock out of this phase as you begin to see an uptrend. Once this accumulation phase is broken, you begin to see highs and lows in the market as we move on to the run-up phase of the market.

2. The Run-Up Phase

Just as the accumulation phase is defined by its resistance to the changes in stock prices, the run-up phase is defined by the price going above this resistance level. The breakout of the accumulation phase results in a high volume of shares as the traders who remained silent during the accumulation phase aggressively purchase stocks. As this period progresses we begin to see a trend in the prices. The highs and lows in the market attract more traders as they begin investing. This result in an upward trend as the market becomes stronger and moves on to the next phase.

How to trade:

This is the best time for a trader to make money. There is a lot of upward movement of prices which is great for momentum traders. Any downward trend during this period is not viewed as a bad thing but rather an opportunity to buy shares. When the market goes down, the shares will get bought up as the market begins to trend again. The run-up phase is best for swing or short-term traders. As this phase progresses, the volatility in the market decreases as prices move slowly every day.

3. Distribution Phase

distribution phase

(Image Credits: Investopedia)

This phase, also known as the reversal stage, is when traders who purchased stocks during the accumulation phase begin to exit the market. A prominent feature of this phase is an increase in the volume of shares but not in its price. The market is usually bullish but the demand does not exceed the supply of shares enough for the prices to increase. There are usually hard sell-offs but not enough to make the market trend downward.

How to trade:

There is a lot of volatility in the early stages as investors begin to pull out of the market which presents a good shorting opportunity as the market reaches the bottom it will bounce back with velocity. The distribution phase is identified through certain chart patterns like the head-and-shoulders top or bottom top. As the phase progresses the market starts to lose its volatility as a range begins to form. This is not the best situation for momentum traders.

4. Decline or Run-down Phasemark down cycle

(Image Credits: Investopedia)

This is the last stage of the stock market cycle and is not a favorable time for most investors. Those traders who bought stocks during the distribution phase hastily try to sell as they are underwater on their positions. However, there are few buyers to meet the sale of shares. This lack of demand drives down the prices of stocks. If there are higher lows in the market for a long period of time, it signifies that the market is headed towards the accumulation stage.

How to trade:

During this phase prices of stocks fall lower than expected so ‘don’t try to catch the falling knife’. A bear marker provides a good opportunity for long trades if the right strategies are used. It is important not to panic and sell during this period because these phases don’t last forever.

Also read:

Conclusion:

Understanding each of the phases in the stock market cycle is essential to making the right decisions when it comes to buying and selling stock. A good way to study these phases it to study the past chart trends of particular stocks. You can identify certain indicators at each phase. Finally, always remember this quote by Yvan Byeajee- “Trading effectively is about assessing probabilities, not certainties.”

winner's curse- investing psychology

Investing Psychology: Winner’s Curse

Investing Psychology- Winner’s Curse :

Have you ever had a chance to participate or witness an auction?

If yes, then you would relate to this better! As interesting as the name of this phenomenon sounds, the outcomes are pretty relatable too.

Many statisticians, mathematicians, and successful investors have discovered and scribbled a pretty common sequence of scenarios that happens mostly during the auction. Let’s try to give you an overview of this:

A bidder sitting in an auction and trying to repeatedly bid on an asset often gets intimidated to continue his bidding even if it is not profitable.

As obvious, in such scenarios, the last one to bid gets the asset and hence gets the title of “the winner”.

But has he actually won? What do you think? The inference can be a bit deeper than you are assessing it to be.

Such scenarios are quite noticeable everywhere – from IPL auctions to jewelry auctions to the real estate to the stock market, you might get to see this every time. The phenomenon could be explained clearly with the use of a couple of suitable examples in this article.

“Winner’s Curse” is quite noticeable in the domain of investing. Generally speaking, a newbie tends to fall in such pitfalls quite often! Keep reading this article to know more about the winner’s curse!

Also read: How to Earn Rs 13,08,672 From Just One Stock?

The Auction Scenario:

If you haven’t had a chance to witness an auction yourself then you have a chance to virtually experience it over here!

Basically, an auction is a set up organized by the “current owner” of an asset who is interested in selling the asset to one of the bidders who are participating in the auction. The owner can be a bank or any other financial institution as well.

A set of people who are interested in purchasing the “on sale” entity are called bidders who have the leverage of placing the bids on the entity. The bidding starts with a base price (the one put forward by the “current owner”) and the bidders have to one-up their biddings to own the asset/entity.

The mentioned set of actions is repeated until no bidder out rules the last bidding. As a result, the final bidder gets the asset – sound simple?

Where is the loophole?

Suppose if the real (true value) price for the asset was 1 hundred thousand dollars and if the final bidder claims it for two hundred thousand dollars, would he still be called as a winner?

Psychologically speaking, the overwhelming and competitive environment of bidding in an auction makes the bidder claim the entity at a higher price than what is profitable (admissible).

This overestimation of the final bid for an entity is actually the cause of “winner’s curse”.

winner's curse graph

New to stocks? Confused where to begin?  Here’s an amazing online course for beginners: ‘HOW TO PICK WINNING STOCKS?‘ This course is currently available at a discount. 

What triggers this curse?

They say, “Emotional stability is one key factor when it comes to investing”.

You would have seen various collaborations of multinational companies. In fact, the whopping amount for which the shares for a certain company get sold is quite huge, right? Well, the winner’s curse is actually playing the cards for it sometimes.

In fact, various multinational giants get caught in this trap. Is it emotional friction or winning at any cost? I’d say both.

The human brain works in a pretty competitive way and the reason can be delved into the core of cognitive science. After the “successful bidding” one gets to realize the loss incurred but the dust gets settled by then.

A rapid increase in an entity’s price followed by its contraction is a sequence followed by various financial experts. The strategy works when a number of people get lured by the so-called “lower prices” of the assets and end up paying for it.

Also read: Efficient Market Hypothesis -The Only Theory That You Need to Read Today.

Winner’s Curse in the Stock Market:

Winner’s curse is not new to the stock market. You can notice multiple scenarios in the stock market where the investments of the people are influenced by the winner’s curse. Few of the best examples are:

1. Buying stocks at a high price.

In the stock market, every now and then, you may come across a storyline where people are buying expensive stocks because they don’t wanna lose the opportunity. Here, they are ready to bid a huge price to win that stock. However, purchasing an overvalued stock (only for the sake of winning) is never advantageous for the investors.

2. Investing in IPOs where the insiders are selling their stakes and public is bidding.

IPO is a scenario where a company offers its shares to the public for the first time. During an IPO, insiders like Promoters, Family, Early Investors- Angel capitalist, Venture capitalist etc are selling their stakes to the public.

However, do you really think that the insiders will sell their stakes to the public at a discount?

Anyways, in order to win, the public is ready to bid a high premium (most of the time) for that IPO. However, after the IPO gets allotted to the people, the winner’s curse starts playing its role.

Also read: Is it worth investing in IPOs?

stock market bidding

You might want to steer clear of this the next time you go for a hefty investment, right? Don’t worry you can try out some precautionary measures with which you should do fine at the “war zone”.

Things to Remember while Bidding:

1. Just as analysis and research are two important things to do before making an important investment. Similarly, knowing the true value of the asset you are bidding for is quite important before you even go for it. You should know that you stick to your actions even better once you have the basics cleared in mind.

There must be a fair standard price of the commodity you’d be bidding for. Get to know about it beforehand.

2. Draw a line: Putting aside an emotional mindset is the best thing that you can do while bidding for an asset as emotions and finance don’t mix well together. As soon as you start placing your first bid, you should know where to draw the line. This would help you hold your grounds in a much better way.

3. Know how important it is for you to win: Rational arguments are always better when you are in a confused state of mind. Ask yourself why does winning actually matter to you?

Also read: Loss Aversion- How it Can Ruin Your Investments?

5 Common Behavioral Biases That Every Investor Should Know cover

5 Common Behavioral Biases That Every Investor Should Know.

5 Common Behavioral Biases That Every Investor Should Know.

Ever heard of Tech gender problem? It is a situation where the employer favors male candidate over female thinking women are no good at tech because they are women.

Even one of the biggest companies in the world, Amazon, faced this bias. (Read more here: Amazon’s machine-learning specialists uncovered a big problem: their new recruiting engine did not like women — The Guardian.)

Anyways, gender bias is nothing new. Throughout history, when jobs are seen as more important or are better paid, women are squeezed out. And similar to this one, there are multiple common biases that we can notice in our day to day life.

But, what actually is a bias?

According to Wikipedia– “Bias is disproportionate weight in favor of or against one thing, person, or group compared with another, usually in a way considered to be unfair.”

In other words, it is an inclination or preference that influences judgment from being balanced. Biases lead to a tendency to lean in a certain direction, often to the detriment of an open mind.

Behavioral Biases in Investing:

Investors are also ordinary people and hence they are subjected to many biases which influence their investment decisions. Although it takes time to control the behavioral biases, however, knowing what are these biases and how they work — can help individuals to make rational decisions when they are susceptible to these situations.

In this post, we are going to discuss five common investing biases that every investor should know.

Confirmation Bias

When a human mind is determined towards one particular behavior, it subconsciously rejects the pieces of evidence against it while confirming the ones that go in its favor. This is known as confirmation bias.

Psychologically speaking, an investor would be more inclined towards his pre-occupied information and knowledge about certain kinds of investing. While considering the pros and cons of a certain kind of investment, the buyer would most likely go with what he used to believe until now.

For example: Making an investment in Bitcoin is dangerous and pointless. If this is an investor’s pre-occupied notion then he would most likely not invest in bitcoins in future.

Gambler’s Fallacy

Gambler’s Fallacy is one such proof which states that a human mind often interprets the outcomes of a future event judging by its corresponding past events even if the two are completely independent of each other. It is inspired by the “failures of gamblers” due to their probabilistic illusions to make decisions in casino games.

Gambler’s Fallacy can be very well explained with the help of a basic example involving a coin. For future reference, let’s suppose that the coin is fair with both sides (heads & tails) having an equal probability of landing on top.

Suppose a coin is flipped 10 times and the result of each event was “Heads”. What would you bet for the next coin flip?

Now, if a human bet on the outcome of the 11th flip of the coin to be “Head” seeing the past events, then it can be considered a bias.

The above context does only imply a simple rule: The occurrence of an independent event is not dependent on past events. In this example, the 11th flip of a coin would result in both heads and tails with a 50% chance of being associated with each one of them.

Buyer’s Remorse:

The regret after purchasing a product is called a buyer’s remorse. Here, the buyers may regret that either they overpaid for the product or they didn’t actually need that product.

Nevertheless, purchasing commodities are not the only thing where people feel “buyer’s remorse”. Stock investors are also like ordinary people, and they too feel this remorse after purchasing equities.

“Was buying this stock a mistake?”

“Was my timing right?”

“Did I just buy a lemon of a stock?”

“Is the market going to collapse?”

“What if I lose money?”

In general, investors feel remorse when they make investment decisions that do not immediately produce results.

Herd Mentality:

An investor’s natural instinct goes with the ones of masses, which means that he/she doesn’t seem to have a rational view on a certain investment but is more likely to deviate where the majority mass is moving — this little phenomenon is known as the “Herd Mentality”.

The term has been derived from the natural instinct of a number of sheep walking together in a herd so as to avoid falling into the pitfalls of danger.

Interestingly, you can also find a large population of investing community following herd mentality psychology in making various financial decisions like buying new property or investing in the stock market. Seeing others getting profited with an investment, our brain tells us to go for it without a second thought.

herd mentality

Winner’s Curse

A bidder sitting in an auction and trying to repeatedly bid on an asset often gets intimidated to continue his bidding even if it is not profitable.

As obvious, in such scenarios, the last one to bid gets the asset and hence gets the title of “the winner”. But has he actually won? What do you think? The inference can be a bit deeper than you are assessing it to be.

Such scenarios are quite noticeable everywhere, including investing.

In the stock market, every now and then, you may come across a storyline where people are buying expensive stocks because they don’t wanna lose the opportunity. Here, they are ready to bid a huge price to win that stock. However, purchasing an overvalued stock (only for the sake of winning) is most of the time disadvantageous for the investors. Another example of winner’s curse is bidding in expensive IPOs.

Closing Thoughts

Most biases are pre-programmed in the human nature and hence it might be a little difficult to notice them by the individuals. These biases can adversely affect your investment decisions and your ability to make profitable choices.

Anyways, knowing these biases can help you to avoid them causing any serious damage. Moreover, a good thing regarding these biases is that — like any habit, you can change or get over them by practice and efforts.

buyer's remorse cover

What is Buyer’s Remorse? And how to deal with it?

What is Buyer’s Remorse? And how to deal with it?

Have you ever bought a new pair of shoes that you’ve been planning to buy for a while, but started regretting the purchase as soon as you arrive home? Maybe it was the best deal in the last three months, and you got a discount of over 30% on the original price. Still, you can’t stop thinking that you might have overpaid for that shoe. Or you might start presuming that you didn’t need a new pair of shoes at all and you have wasted the money on it ‘unnecessarily’.

This regret after purchasing a product is called a buyer’s remorse. And don’t worry, you are not different. It happens to everyone.

Nevertheless, purchasing commodities are not the only thing where people feel “buyer’s remorse”. Stock investors are also like ordinary people, and they too feel the buyer’s remorse after purchasing equities. Anybody who has been in the market for a long time might have already experienced investor’s remorse.

In this post, we are going to discuss what actually is buyer’s/investor’s remorse and how one can deal with it.

buyer's remorse pic-min

Investor’s Remorse

Investors sometimes feel remorse when they make investment decisions that do not immediately produce results. The guilt is more prominent when the share price starts going down.

Here are a few general questions that come in the mind of every investor in such situations:

“Was buying this stock a mistake?”

“Was my timing right?”

“Did I just buy a lemon of a stock?”

“Is the market going to collapse?”

“What if I lose money?”

Moreover, the investor’s remorse become stronger when people watch the latest news. The TV analysts/anchors make the current facts (which were not available at the time of investment) look so obvious that people start regretting their decisions at once. However, it is always easier to see into the past than to estimate the future. As Warren Buffett used to say:

“In the business world, the rearview mirror is always clearer than the windshield,” -Warren Buffett

There’s a very fair chance that you might have taken the best decision based on all the available information at the time of your investment.

Also read:

Buyer’s Remorse Effects

In general, there can be two effects of the buyer’s remorse.

  1. Impulsive decision to return (or sell) the product which may be well reasoned and a smart idea in the first place.
  2. Justifying the investment and refusing to accept the mistake.

Both these effects can be adverse for the investors.

Leaving your position in a well-researched stock just to get over the guilt is never a good idea. On the other hand, becoming adamant on your investment decisions may be damaging for your portfolio and will prevent you from learning a valuable lesson.

Ways to deal with Buyer’s Remorse:

The best way to deal with buyer’s/ investor’s remorse is to re-examine your purchase (both risks and opportunities).

Stand with your stock if the fundamentals are the same and the reasons for purchasing that share is still valid. On the other hand, if you made a mistake, then fix it.

Here are two additional ways which can help you to avoid buyer’s remorse:

  1. Avoid impulsive buying or selling: It’s always a better approach to research intensely before buying or selling. Taking an informed decision will build confidence towards your investments, even if they do not show short-term results.
  2. Have a margin of safety (MOS): If the calculated intrinsic value of a stocks turns out to be Rs 100, then give your calculations a margin of safety of 20–30% and purchase the stock only when it is trading at a price below Rs 70–80. Having a MOS while buying shares will mitigate the risks and safeguard your investments. (You can use Trade Brains’ online calculators to find the intrinsic value of the stocks).

Final tip– Always remember that buyer’s remorse is natural and inbuilt human psychology. But acting or reacting to this guilt depends on the person. The ability to handle buyer’s remorse will make you a better investor.

the law of small numbers cover

What is the Law of Small Numbers? Meaning, Examples & More.

What is the Law of Small Numbers? Meaning, Examples & More:

Often we don’t realize but the game of investment can be closely connected with hardcore psychology. You must have heard many people say: research before you invest.

While that is absolutely true, you must also know what to research for. While being on a searching spree, generally, you find many online (or offline?!) resources which tend to favor a kind more than the other. Enter, The Law of Small Numbers.

A data has multiple dimensions and each one of them is responsible for inferring the data in a different context. Statisticians tend to choose the attributes (read dimensions) very carefully. The choice of attributes is not random, of course. A couple of data mining techniques such as “Decision Tree Induction” can carry out specific attribute selection methods to take exact inference.

Coming back to the real context, “The Law of Small Numbers” is actually a law confirming fallacy. It says that the length of data is an important consideration for a data as the probability of it being relatable is directly correlated to the length of the data. Read more of this article to get to know about “The Law of Small Numbers”.

The Loophole in the Probabilistic Inference:

Imagine our whole world running on the rules of probability! However fancy it might seem, it is not actually possible otherwise you would be having a fair chance to everything, wouldn’t you? The point is that probabilistic results are always relative. You can neither expect nor confirm the extent of its reality.

The source of the data that you are picking for your hypothesis and inference is of great importance here. Rather than completely shifting your focus to what does a data infer, you might want to shift your focus to where the data has been picked from (and possibly how).

Random Sampling is one of the famous probabilistic sampling techniques which goes with a very basic rule: Each element has an equal and a fair chance of getting picked. Now, nothing in this world is absolutely defined by itself and so the fair & equal chance is quite a hypothesis.

Also read:

Causal Explanation/Causal Narrative:

A Causal Narrative is something which is derived from general human behavior. You must have not realized but we humans have always indulged in pulling out inferences from the pieces of information that are provided to us. The data, however, is not always full-proof.

To put it in clearer words, the data can be churned out as a result of random sampling which makes it even more difficult to put a word to the analysis done through its inferences. You must note that Random Sampling inferences are sometimes misinterpreted as the whole account of the data is not clear and was in fact collected randomly. Similarly, a causal explanation of a data which has been collected or sampled randomly does not always pull out exact inferences.

Why? – Because we are trying to infer a cause for something which has no cause (by its nature).

Hence, equal attention must be paid to the method which has been used for collecting the data.

Sparse Population & an Example:

In a famous statistical puzzle related to kidney cancer among the 3143 counties in the US, the data had two interesting (& confusing) inferences at the same time.

Inference 1: US Counties with the lowest rates of Kidney Cancer have the following attributes:

  • Mostly Rural
  • Sparsely Populated
  • Located in traditionally Republican states in the Midwest, the South, and the West.

Inference 2: US counties with the highest rates of Kidney Cancer have the following attributes:

  • Mostly Rural
  • Sparsely Populated
  • Located in traditionally Republican states in the Midwest, the South, and the West.

Now, how two exactly opposite (in nature) inferences can have exactly the same attributes?

The key attribute or factor here in this example is the sparse population of the data collected in the first place. In fact, a misinterpretation of the data source has been done because of the sparsely populated data as a small population (generated with a random chance) is inclined to show greater extremes in terms of deviations.

Let’s understand this context better in terms of another famous example:

Take an example where a jar of equal red and green marbles is placed and you need to pick 4 marbles out of the jar randomly. The possible outcomes noted are:

  • 2R/2G <- Actual Population Mean
  • 3R/1G or 3G/1R
  • 4G/4R <- extreme outcome (has 12.5% chance)

When the Sample sizes are increased and for example let’s say we’d be picking out 7 Marbles instead of 4 then the probability of extreme deviation (i.e. picking out 7 same colored marbles) is reduced to only 1.8%.

This result is in fact derived from the very famous law –  “The Law of Small Numbers”.

(Credits: Kevin deLaplante)

Conclusion

The law of small numbers explains the Judgmental bias which occurs when it is assumed that the characteristics of a sample population can be estimated from a small number of observations or sample data.

Therefore, while studying any survey, the length of data should be given an important consideration as the probability of it being relatable is directly correlated to the length of the sample.

gambler's fallacy

What is Gambler’s Fallacy? [Investing Psychology]

What is Gambler’s Fallacy? Investing Psychology:

Statistics is always surrounded by two kinds of events – dependent and independent events. While the dependent event’s calculations are governed by different approaches such as the Naïve Bayes theorem and full joint distribution tables, the calculations involving independent events are quite easy to follow.

New technology and data mining techniques are all about using the past data in order to make the predictions true about the future. However, is this always true? Does the future data always depend upon its correlated past data? Even statisticians were not too sure of this.

Gambler’s Fallacy is one such proof which states that a human mind often interprets the outcomes of a future event judging by its corresponding past events even if the two are completely independent of each other.

Gambler’s Fallacy is inspired by the “failures of gamblers” due to their probabilistic illusions to make decisions in casino games. Also known as “Monte Carlo” fallacy, the gambler’s fallacy has been used a number of times for various conformances and inferences.

In this article, we are going to explain the basics of this fallacy and would also consider a few famous examples to understand the term and its context in a better way. Let’s start!

Also read: The First Golden Rule of Investing -Avoid Herd Mentality.

The Coin Toss Example

Gambler’s Fallacy can be very well explained with the help of a basic example involving a coin. For future reference, let’s suppose that the coin is fair with both sides (heads & tails) having an equal probability of landing on top.

Suppose a coin is flipped 10 times and the result of each event was “Heads”. What would you bet for the next coin flip?

Now, if a human bet on the outcome of the 11th flip of the coin to be “Tails” seeing the past events, there’s a 50% chance of him to fail. 

The above context does only imply a simple rule: The occurrence of an independent event is not dependent on the past events. In this example, the 11th flip of a coin would result in both heads and tails with a 50% chance of being associated with each one of them.

Therefore, the prediction of an event can’t be made seeing its past outcomes if the events are independent of each other.

Psychological Thinking & “The Gut Feeling”

Something which our brain is too good at is making inferences. A human brain is very quick at picking up things, assembling them, joining the pieces together, and making an inference. The probabilistic approach here is not always true, however.

A Human brain is just incredible at churning out new patterns and associations that it might create illusions. To put it in plain and simple words:

Our brain can deduce patterns that even don’t exist in reality.

That alone might cause problems and thus exist fallacies like “The Gambler’s fallacy”. In the coin toss example, our brain might work in two ways:

  1. It could think that on most of the coin flips, heads are turning up so, in the 11th flip, it might show a ‘head’ again. OR
  2. It could think that since most of the coin flips have shown “heads” on them, maybe it is going to show the “tails” now.

Both of them, however, are true BUT ONLY COLLECTIVELY.

In the coin toss example, the probability of the 11th flip showing “Heads” and “Tails” is equal and is exactly 50% for both of them.

Also read: Investing Psychology: Winner’s Curse

Gambler’s Fallacy and Investing:

You would think what do these both terms have to do with each other? However, you must know that it is a common practice in the investing domain as well. Investors tend to liquidate their positions (or their bet) over something which is long overdue – again, a classic example of the Gambler’s Fallacy.

For example, if a stock is continuously making new highs for the last 4 consecutive days, few may think that it will correct on the 5th day, so better to leave the position. On the other hand, the rest might argue that it will continue to rise because of the momentum.

An inaccurate understanding of basic terms related to probability can make one invest in wrong places. Now, I would like to ask you the same question again!

In the coin toss problem mentioned above, how much would you like to bet on heads or tails or both?

The correct answer would be to bet half of your money on heads and half of it on tails – pretty simple, right? Not because tails is overdue, not because heads are on a streak but because both of them are having an exactly equal probability of landing on top.

Also read: Get Rid of- Confirmation Bias For Good!

Summing up:

If you pay heed to the name of this fallacy; the gambler’s fallacy, you would relate it to a casino game. The co-relation is justified!

Most of the games in a casino or gambling games have sequences that are randomly generated and are statistically independent. Making a prediction on the outcomes of the events involving the sequence of these games isn’t easy and sadly can’t be derived from the mathematics of probability. Therefore, one would find it purely random and “lucky” to get a winning sequence – the Gambler’s Fallacy is rolling its dice in the background.

herd mentality

The First Golden Rule of Investing -Avoid Herd Mentality.

Herd mentality is a very common investing psychology seen in most investments done by the people. Here, a majority of past investment done by the mass constitutes a refined data to show inferences.

An investor’s natural instinct goes with the ones of masses, which means that he/she doesn’t seem to have a rational view on a certain investment but is more likely to deviate where the majority mass is moving – this little phenomenon is known as the “Herd Mentality”.

The term has been derived from the natural instinct of a number of sheep walking together in a herd so as to avoid falling into the pitfalls of danger.

herd of sheeps

If you look around, our daily actions are based on this little psychological term that we have just read about. If we break down the context of “Herd Mentality” to its core, we would find out that the concept is more related to “how do the natural instincts work for humans”.

Interestingly, you can also find a large population of investing community following herd mentality psychology in making various financial decisions like buying new property or investing in the stock market. Seeing others getting profited with an investment, our brain tells us to go for it without a second thought.

Why does herd behavior happen?

Although investing collectively is harmful and irrational, however, most of the people choose this tendency because of two basic (human) reasons:

  1. Strong social pressure: Most of the people like to be accepted by a group, rather than branded as an outsider or outcast. Following what the others are doing is a natural way of becoming a member of that group. That’s why following the herd is the logical tendency to avoid social pressure.
  2. Irrational belief that a large number of people cannot be wrong: In general, people believes that the larger the group of people involved in any decision, the lessor is the chance of the decision being incorrect. Again, this is a natural instinct of humans. Until and unless anyone has little experience and expertise of the domain, he/she avoid directly opposing the masses.

Herd Mentality in Stock Market:

Many of the worst financial crisis in the stock market like dot-com bubble or the economic recession of 2008 can be attributable to the same human tendency- HERD MENTALITY. Here are few examples of herd mentality in the stock market from day to day market scenario:

  • Buying a stock which everyone else is buying :

The buying decision of an average investor can be easily influenced by the actions of his friends, neighbors, or acquaintances. Suppose all your friend bought one specific stock whose price is rising day by day. Further, all your friends are making fun of you that you didn’t buy that stock when then initially recommended. What would be the natural instinct of an average investor here?

If everyone around you is investing in a particular stock, then the tendency for potential investors is to do the same. However, this strategy never turns out to be fruitful for an investor in the long run.

herd mentality stocks

  • Investing in ‘Hot’ Stocks

Hot stocks are the darlings of the new investors as these stocks are the ones which are constantly in news and everyone is talking about its upside potential. However, hot stocks become ‘hot’ only when the majority or herd moves their money in this stock after seeing so many other investors doing the same thing.

The ones who are actually going to get benefit from these stocks are the ones who invested in these stocks way before it became a hot stock. The rest (herd) who puts their money in these stocks (when the prices are already high) is going to lose their hard earned money in the stock market.

New to stocks? Confused where to begin?  Here’s an amazing online course for beginners: ‘HOW TO PICK WINNING STOCKS?‘ This course is currently available at a discount. 

How to Avoid the Herd Mentality and Make Better Investment Decisions?

It is quite clear by now that judging “collective” behavior wouldn’t do any good when it comes to making an important decision about investments. Most naturally, following what majority of people has chosen is always a tempting and “safe” option to go for. However, without foreseeing the background, one can’t be sure of any important decision.

Jumping on a bandwagon without knowing every bits and piece of details about it is something unnecessary in the investment domain. Before making an investment, make sure that you do the following things:

1. Do your research: A little bit of research never hurts. In fact, this should be one’s habit before making any investment. You can use various references to know the details about any kind of investment you want to jump into. In fact, the more you read, the better it would be.

2. Consult a financial advisor: If you cannot give enough time for the research/study, then why not consult an expert. He/she will be able to give you a better advise compared to your amateur friends or neighbors. 

At last, use your wit to take your decision!

Also read: Loss Aversion- How it Can Ruin Your Investments?

Get Rid of- Confirmation Bias For Good

Get Rid of- Confirmation Bias For Good!

Investing Psychology: Confirmation Bias

“People only listen what they like to listen” is a generic statement which has deep-rooted psychological meanings.

If you consider psychology and investment, both go hand in hand. Since the two are closely related, you would know that one changes (or alters) the effects of the other. One such psychological phenomenon is known as “Confirmation Bias”.

Let’s put this phenomenon forth with an example:

While purchasing a phone online, do you take the efforts to check for its reviews online? If yes, congratulations, you are an intelligent buyer.

However, the point is something different. Suppose that you really wanted to buy this phone for a very long time and have finally managed to have the savings to purchase it. Now, when you are reading the reviews, you would actually consider every positive review about the phone but will mentally decline the negative ones. Sounds familiar?

This concept is related to “Confirmation Bias”. Now, this was a basic idea just to give a glimpse of how this works to our readers. As we will proceed with this article, we will discuss a bit more about the confirmation bias and how it can affect your investment decision.

Human Mind and Biases:

As complex as our human mind is, scientists have been able to infer different phenomena related to the subconscious human mind. The confirmation bias is a result of one such phenomenon. Before moving further, let us discuss – what does the term bias mean?

When a human mind is determined towards one particular behavior, it subconsciously rejects the pieces of evidence against it while confirming the ones that go in its favor.

While we as human beings are found doing this all the time, these actions can be pretty dangerous while making an investment.

Also read: Loss Aversion- How it Can Ruin Your Investments?

Investment and the Confirmation Bias:

Psychologically speaking, an investor would be more inclined towards his pre-occupied information and knowledge about certain kinds of investing. While considering the pros and cons of a certain kind of investment, the buyer would most likely go with what he used to believe until now.

For example: Making an investment in Bitcoin is dangerous and pointless.

If this is an investor’s pre-occupied notion then he would most likely not invest in bitcoins in future. Moreover, the information that will be fed to the investor in favor of this notion would be acceptable to him. On the other hand, the information that would oppose this notion would be rejected by the investor.

bitcoins

Most obviously, this particular bias is not only limited to investment but prevails in almost each and every domain. If you notice closely, the confirmation bias restricts you to consider only one point of view and pushes you to almost reject the others which are lethal to decision making in investment. In fact, in order to make good investment decisions, one needs to consider a scenario multi-dimensionally.

If one fails to do so, he can make wrong investment decisions possibly incurring heavy losses in future.

Also read: Why Nobody Talks About VALUE TRAP? -The Bargain Hunter Dilemma

Confirmation Bias in the Stock Market:

There are various scenarios in the stock market where you can find confirmation bias influencing the investment decision of an investor. Here are few examples:

  • When an investor finds a ‘hot’ stock in any financial website/magazine, he/she will research it further only to prove that the supposed ‘potential’ is real. They might look at plenty of positive news regarding that stock. In the same time, they’ll ignore the red signs, just by making excuses like ‘It’s not going to affect the company much’.
  • If the stock price of a company starts falling, the investors start looking at all the negative flags only. Even if the setbacks are temporary and the company might have a good long-term future potential, however here the investors are more biased to the negative flags and totally ignore the positive factors concerning that stock.

confirmation bias stock market

New to stocks? Confused where to begin?  Here’s an amazing online course for beginners: ‘HOW TO PICK WINNING STOCKS?‘ This course is currently available at a discount. 

How to Avoid Confirmation Bias? 

The easiest approach to avoid confirmation bias while investing it to take an expert advice from a trained financial advisor.

Don’t we always take a second opinion from our friends or colleagues for every little thing we do? Be it selecting an outfit for an important event to taking major life decisions, a second opinion actually helps in backing up our decision. Therefore, you would want your second opinion to be totally unbiased and reasonable, wouldn’t you? That’s what expert advice is for.

Make sure that you ask for an advice from an experienced investor or from an expert financer. An expert advice makes you see the alternatives in a better way.

Nevertheless, with practice and experience, even an individual investor can avoid confirmation bias, without even taking help of an advisor. Here are two important steps that you need to contemplate in order to avoid confirmation bias.

1. Look at each and every dimension: Considering only pros or only cons about an investment would make the information partial (incomplete). Hence you need to view a scenario from different angles in order to make a backed-up decision.

2. Take some time before you pop a decision: Time is an important factor and it actually helps in unfolding various new information with it. An intelligent investor knows the amount of time he needs before he could finalize his decision. 

Conclusion:

Confirmation bias is not new to the investing world and do not regret if you have been following this psychology even without knowing. However, now that you understand that confirmation bias can adversely affect your investment decisions, you need to avoid it.

Although confirmation bias is a human instinct- nevertheless, you can control/avoid it with practice and experience.

Also read: Case Study: How 100 shares of WIPRO grew to be over Rs 3.28 crores in 27 years?