The author of the book is Late Parag Parikh. He was one of the finest and respected investors from India, before he started his mutual fund business he was running a portfolio management service whose mission statement read, “We create high net worth individuals, we do not chase them”.
He went every year to OMAHA, USA to attend Berkshire Hathaway meetings and listen to the greatest investor of all time Mr. Warren Buffett. While going to the airport from the meeting he died in a car accident in the year 2015.
Mr. Parag believed in long-term wealth compounding and value investing and delivered above-average returns over many years in his PMS service as well as through his mutual fund business.
In the book Stocks to Riches, he has discussed in detail how bias influences us to make decisions in different situations which causes us to harm our financial well-being. Following are the 5 takeaways for stock market investing & 1 on personal finance.
1. Introduction to behavioral finance
“Behavioural finance is the study of how emotions and cognitive errors can cause disaster in financial affairs”. This explains how humans act based on their emotions rather than using their rational minds.
The stock market in India has a delivered return greater than any other asset class over the last 35 years period, but still, we hear people say they suffered huge losses or the stock market is a bad investment. The reason for this is, humans make decisions from their hearts instead of their minds. Emotion dictates our behavior which causes problems while taking the right decision.
To explain this point in more detail author has given a real-life story:-
One of the author’s clients had just started a coaching classes with his colleagues/partner. The classes were running successfully and the capacity was full soon.
But after few days, students complained that his partner was short-tempered. And asked the author’s friend to fire him otherwise we (students) will leave the classes.
After few days this partner stopped coming to the classes, the students thought the author’s friend had fired him. But after few days author’s friend learned that his partner was ill and was suffering from a brain tumor and had to go under an operation.
He communicated the same to his students as soon as he heard the news. Students went to meet the short-tempered professor with flowers and prayed for his early recovery so that he could come back to teach them.
This story clearly explains that humans are emotional beings and our behavior and decisions are influenced by our emotions.
In the stock market, behavior finance explains why we:
- hold on to stocks that are crashing;
- sell stocks that are rising;
- ridiculously overvalue and undervalue stocks;
- jump in late and buy stocks that have peaked in a rally just before the price declines;
- take desperate risks and gamble widely when our stocks fall;
- avoid taking the reasonable risk of buying promising stocks unless there is an absolutely ‘assured’ profit;
- Never find the right price to buy and sell stock;
- prefer fixed income over stocks;
- buy when we have to sell and sell when we should be buying;
- Buy when because others are buying and sell because others are selling.
2. Loss aversion
It is proven that a human being feels three times more pain than the pleasure of an equal amount of gain. For Example, if you bought a stock at ₹100 and sold it at ₹125 we would be less happy as compared to the pain if at the same time you had sell stock for ₹75.
‘The investor is more scared of loss than the risk’ this is one of the tenets of behavioral finance. For example this probably is the reason why investor invests in fixed income securities like a fixed deposit. Even after knowing that after inflation and taxes the returns will be negligible.
Loss aversion pushes investor to sell companies which are in profits and buying stock which is delivering negative returns. In this context, Peter Lynch said, “Cutting the flowers and watering the weed”.
3. Sunk cost fallacy
Sunk cost fallacy bias occurs when an investor takes actions in order to complement their past actions which they don’t like. For example, if a student took up a course which he didn’t like but out of four years he has completed three years of the course.
He will still continue the course as he has already invested 3 years. This may prove to be counterproductive as he does not have an interest in the subject.
It happens many times, for example, when we go to a movie and we find the movie not so interesting, instead of leaving the theatre we still watch the entire movie because we have paid for the ticket. But at the same time, we do not think about the time and energy we are wasting by watching the boring movie
Example in the context of the stock market. When an investor buys a stock and if the stock falls he would average down his cost price because he thinks that the stock is undervalued. This is done by him to justify his past action of purchase of the share.
Also, read other book summaries: The Unusual Billionaires (book summary)
4. Decision Paralysis
Not taking a decision is also a decision which means that if a people inherit 50 lakh of stock portfolio from are our rich relative, we would not make changes according to our requirement to which may not be a wise decision. This happens because by our nature we tend to resist change.
The reason we do not take decision are:
- fear of going wrong
- the possibility of losing
- to avoid looking foolish
- unwilling to take risks
Maintaining a status quo can be harmful to our financial well-being. for example when the market is in a full run and everybody is optimistic about the future.
All type of companies even junk stocks become favorites of the market during such time investors pile up on such stocks and agrees with the status quo.
And when the bear market starts to come around they still hold on to such stocks and swear that when these stocks will become saleable they surely do so.
But again when the market becomes bullish they still hold onto them. The best thing to do while taking a decision to avoid this bias is to think about the worst-case possibility.
This is explained best in Mohnish Pabrai’s book ‘The Dhandoo investor’.
He explains with an example when Patel moved to America they had nothing. So they bought motels on loan from banks when the motel industry was suffering.
The downside in their case was nothing because they had nothing to lose and if they were successful they would have a motel and a livelihood as well as a place to live. Today a majority of motels in America are owned by Patel’s.
5. Mental heuristics
Which line is longer?
Human brains have over the years developed to identify patterns, but this can be hazardous to our financial well-being in this complex world. Definition of the word heuristic refers to the process by, which people reach conclusions usually by trial and error. This leads us to develop thumb rules for activities that may not be accurate always.
For example: When sector leaders report good profits the stock price of not only the leaders will go up but along with them the other junk and penny stocks in the same sectors will also go up for no reason.
This heuristic is called representative heuristic, where our brains form a representation among the thing which are related to each other in some or other ways.
Both lines are of same length.
In the book, the author has written about various heuristic the list is as follows:-
- Availability heuristic
- Representative heuristic
- Saliency heuristic
- Anchoring & Adjustment.
- Herd Mentality
- Size Bias
- Pattern Recognition
6. Mental accounting
Mental accounting bias is a topic of personal finance. Mental accounting bias occurs when people put their money into separate categories, separating them into different mental accounts, based on say, the source of the money, or the intent of the account. Mental accounting is also known as the “two-pocket” theory.
Remember Sushil Kumar who won the KBC show. He later went bankrupt after few years. Even though he was a qualified teacher still was not aware of mental accounting.
Plan of action
1. Always pay with a Cash or Debit card.
Plastic money like credit cards can be delusional. Small money can compound into huge amounts.
2. Be alert while spending big money.
This includes house and capital goods like a washing machine. So be aware of each and every purchase in this segment as people ignores about few additional costs like insurance and service contract.
3. Sleepover windfalls (Windfalls mean lottery and other types of winnings).
This means that one should not account for money received via this type of source differently.
For example:- A person wins a lottery he should go to a financial adviser and ask him about how to invest according to his requirement like retirement, children’s education, etc.
Also, an important point to note the tax rate on this types of income are highest all around the world in India it is flat 30% (in some cases it is cut as TDS (full form tax deducted at source))
Solution:- Treat all money as earned money to get out of the trap.
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Economics theory explains that a human is a rational being and he takes all decisions only to maximize his wealth which may not be true in the real world.
Mental biases are also beneficial in some cases for example if we have enrolled for a gym membership to maintain our health but we neglect it. But because we have paid for the membership it creates a sunk cost fallacy in our mind and we tend to go to the gym.
According to me, we cannot totally overcome mental bias, but we can minimize the error and achieve financial success while investing.
Disclaimer: Some of the examples in the article are given from my personal learning and are not from the book.