Foundation — Standard finance, behavioural finance, and how people actually decide

A family of four arrives hungry in an unfamiliar market at nine at night. There are perhaps forty places to eat.

The standard finance approach would be to read every menu, compare prices, check hygiene ratings, interview departing customers, and select the optimal restaurant. It would take ninety minutes and the children would be asleep.

What they actually do is walk two lanes, glance at three places, notice that one is crowded with families, and sit down. Is it the best restaurant in the market? Almost certainly not. Is it satisfactory and sufficient? Yes.

That is exactly the workbook's SATISFICE — a coined word, a combination of SATISFACTORY AND SUFFICIENT. And the three limits are all present: TIME (the children), INFORMATION (an unfamiliar market), and ABILITY TO COMPREHEND (forty menus at once).

The three steps follow: process only the information which is MANAGEABLE; apply RULE OF THUMB — "a crowded place is a good place"; and select a SATISFICING solution.

And the crucial point, which the workbook italicises in its own way: BOUNDED RATIONALITY IS NOT IRRATIONAL DECISION MAKING, BUT RATIONAL DECISION MAKING UNDER CERTAIN BOUNDARY CONDITIONS. The family did not behave stupidly. They behaved sensibly inside the constraints they actually faced — which is what every investor does when confronted with four thousand listed companies.

Watch a small trader on a day when two things happen. A customer owes him Rs 5,000 and offers to settle today at Rs 4,800 — he takes it immediately, because the certain money in hand beats the risk of waiting. The same afternoon, a supplier demands Rs 5,000 he owes and offers to settle at Rs 4,800 today — he says he will pay next month, hoping something will turn up.

He is risk-averse on the gain and risk-seeking on the loss, and the workbook names both halves: PEOPLE ARE RISK-AVERSE ABOUT GAINS (REALIZING IT EARLY) BUT RISK SEEKING ABOUT LOSSES (HOLDING TO THEM LONGER).

Standard finance cannot accommodate this. It assumes investors are uniformly RISK AVERSE, and so cannot explain why the same man behaves in opposite ways within six hours.

The consequence in a portfolio is the DISPOSITION EFFECT — holding "losers" too long and selling "winners" too early, in Shefrin and Statman's words, because "people dislike incurring losses much more than they enjoy making gains, and people are willing to gamble in the domain of losses."

And the third premise explains the force behind it: MONETARY LOSSES HURT MORE THAN MONETARY GAINS. The pleasure of Rs 10,000 gained does not balance the pain of Rs 10,000 lost — which is why the trader will risk a great deal to avoid crystallising a loss he has, in truth, already suffered.

Two engineers meet at a reunion. Both now earn Rs 18 lakh. One is delighted — he started at Rs 9 lakh and has doubled. The other is miserable — he took a pay cut from Rs 26 lakh when his company shrank.

Same number. Opposite feelings. Nothing about Rs 18 lakh explains it.

That is prospect theory's first premise: CHOICES ARE EVALUATED RELATIVE TO A REFERENCE POINT (WHICH IS THEIR WELL-BEING). People do not evaluate outcomes in absolute terms at all — they evaluate changes from wherever they happen to be standing.

The same thing happens in every portfolio review an adviser conducts. A client whose fund is at Rs 12 lakh reacts entirely differently depending on whether he remembers investing Rs 10 lakh or remembers the peak value of Rs 15 lakh. The portfolio is identical; the reference point is not.

This is also why the workbook warns that at the time of evaluating the performance of the portfolio, DECISION MAKING FRAMES MAY LEAD TO SUB-OPTIMAL JUDGMENTS. An adviser who presents performance against the peak invites despair; one who presents it against the cost invites complacency. Neither number is wrong, and the choice of which to show is itself a framing decision.

A man receives Rs 50,000 as his annual bonus and Rs 50,000 as a gift at a family wedding. He puts the bonus into a recurring deposit and spends the wedding money on a holiday.

Ask him why and he will say the wedding money was "extra." But money has no memory. Fifty thousand rupees is fifty thousand rupees, whatever envelope it arrived in.

That is MENTAL ACCOUNTING, developed by Richard Thaler in 1999 — an information processing bias in which people treat one sum of money DIFFERENTLY FROM ANOTHER EQUAL-SIZED SUM, based on WHICH MENTAL ACCOUNT THE MONEY IS KEPT.

The technical word is FUNGIBILITY, and the workbook footnotes it precisely: fungibility is the fact that ALL MONEY IS INTERCHANGEABLE AND HAS NO LABELS. People treat money LESS FUNGIBLE THAN IT REALLY IS, and are willing to TAKE MORE RISK with money that is perceived as WINDFALL GAIN OR LOTTERY WINNINGS.

It shows up in portfolios too. Investors think about their wealth as if it consists of various buckets — retirement fund, children's education fund, marriage fund — which often results into selection of assets under each bucket THAT COULD HAVE BEEN AVOIDED IF THEY CONSIDER THEIR OVERALL INVESTMENTS TOGETHER.

Thaler's own prescription is the remedy: consider money as FUNGIBLE and TREAT ALL MONEY THE SAME, REGARDLESS OF ITS ORIGIN OR USE.

Two shops sell identical mince. One sign reads "95% LEAN." The other reads "5% FAT."

The meat is the same. The sentence is the same. And the first shop sells more.

The workbook gives exactly this example under ATTRIBUTE FRAMING — beef that is 95% lean vs 5% fat — alongside RISKY CHOICE FRAMING: the risk of LOSING 10 OUT OF 100 LIVES vs the opportunity to SAVE 90 OUT OF 100 LIVES. And it draws the conclusion: THE OUTCOMES OF BOTH THE CHOICES IN BOTH THE SCENARIOS IS THE SAME, HOWEVER PEOPLE MOSTLY OPTED FOR SECOND OPTIONS IN BOTH THE SCENARIOS.

Framing bias is defined as an information-processing bias in which a person ANSWERS A QUESTION DIFFERENTLY BASED ON THE WAY IN WHICH IT IS ASKED.

For an adviser this is not an amusing quirk — it is a professional hazard. The workbook names the precise danger: investors have to rise above this bias WHILE FILLING RISK TOLERANCE QUESTIONNAIRES for the purpose of determining risk appetite, AS THAT WOULD INFLUENCE THE ASSET ALLOCATION CHOICES GREATLY.

A question that asks "how much could you bear to lose?" and a question that asks "how much growth would you like?" will produce different asset allocations for the same client — and the adviser wrote the questions.

A buyer walks into a carpet shop in Jaipur. The shopkeeper does not ask what he wants to spend. He unrolls a carpet and says "Rs 90,000."

Whatever happens next, the conversation now lives in a world where Rs 90,000 exists. Settling at Rs 55,000 feels like a triumph — even if the carpet was always worth Rs 40,000.

The workbook names this exactly: ANCHORING BIAS occurs when people RELY ON PRE-EXISTING INFORMATION when they make decisions... DURING NEGOTIATIONS, IT IS OFTEN OBSERVED THAT THE FIRST PRICE MENTIONED BECOMES ANCHOR PRICE DURING THE ENTIRE NEGOTIATIONS.

And the mechanism is not merely that the anchor is remembered. THIS MAKES ALL THE SUBSEQUENT INFORMATION TO BE SEEN IN LIGHT OF THE ANCHOR INFORMATION. The anchor becomes the lens.

In markets the anchor is usually a price the investor once saw. The workbook's second example: making a judgement about WHERE THE PRICES OF THE STOCK COULD BE ON THE BASIS OF ITS PAST PERFORMANCE.

Every adviser has heard it: "I will sell when it comes back to Rs 800." The company may have changed beyond recognition, but Rs 800 is where the client is standing — and he will stand there for years. The price he paid, or the peak he once saw, has become a fact about the stock in his mind, when it is only a fact about his own history.

A family holds 2,000 shares of a company the grandfather bought in 1978. It pays almost no dividend, the business is in decline, and it fits nothing in their financial plan. Ask anyone in the family whether they would buy those shares today and the answer is an immediate no.

Ask them to sell and the conversation stops.

That is ENDOWMENT BIAS — an emotional bias in which people VALUE AN ASSET MORE WHEN THEY HOLD RIGHTS TO IT THAN WHEN THEY DO NOT.

The workbook identifies its two attributes: VALUING OWNERSHIP and LOSS AVERSION — so it is not simple sentiment but a compound of the two, which is why it is so difficult to argue a client out of. And it names the very case: it has been generally observed that INHERITED STOCKS ARE RARELY SOLD EVEN IF THEY DO NOT FIT INTO THE OVERALL INVESTMENT STRATEGY.

The self-justifying story follows: when the investor believes that the stock she owns is MORE VALUABLE THAN OTHERS, and WHEN THE MARKET WILL RECOGNISE, SHE WOULD MAKE SUPERIOR RETURNS.

The test an adviser can offer is the simplest one in behavioural finance, and it takes a single sentence: "If you did not already own this, would you buy it today at this price?" If the answer is no, then holding it is a decision — and it is the same decision as buying it.

A cinema hall with one narrow door holds a thousand people comfortably — as long as nobody is in a hurry. The moment someone shouts, the same door that admitted them in an orderly hour cannot release them in five minutes.

That is the structural truth about crashes, and the workbook puts it plainly: CRASHES ENTAIL SIMILAR PROCESSES LIKE BUBBLES, BUT IN REVERSE ORDER, AND EVERYONE COMES TO SELL AT THE SAME TIME... SUCH JOSTLING AMONG INVESTORS/TRADERS TO GET RID OF STOCK LEADS TO CRASHES.

The entry is just as crowded, and Kindleberger (1978) describes it: a SHARP RISE IN ASSET PRICE IN A CONTINUOUS PROCESS, WITH THE INITIAL RISE GENERATING EXPECTATIONS OF FURTHER RISES AND ATTRACTING NEW BUYERS, GENERALLY SPECULATORS, INTERESTED IN PROFIT FROM TRADING RATHER THAN INVESTING FOR LONG TERM.

And why do the clever people not stop it? Because arbitrageurs suffer from a SYNCHRONISATION PROBLEM — they cannot coordinate the selling — besides difference in INDIVIDUAL INCENTIVES to time the market. The bubble persists not because nobody sees it but because nobody can be sure the others will move at the same moment.

The workbook offers the finest illustration in all of finance. Isaac Newton rode the South Sea Bubble in 1720, got out at GBP 7,000 having made GBP 3,500, then re-entered and lost GBP 20,000. His verdict is worth memorising word for word: "I CAN CALCULATE THE MOTIONS OF HEAVENLY BODIES, BUT NOT THE MADNESS OF PEOPLE."