Meet the 'Mind Traps'

Here is a quick test to determine your Investment Quotient (IQ).
Stock A at Rs100 has a 7% chance of dropping below Rs100 in the next five years.
Stock B at Rs200 has a 93% chance of gaining from this price level in the next five years.
Which is a safer investment bet--Stock A or Stock B?
In case you picked Stock A, you are being very smart or foolishly brave.
In case you picked Stock B, you are one among the many investors who fall for a very common mental illusion caused by "Framing" according to behavioural scientists.

In simple words, "Framing" stands for human fallibility to decide based on the way information is presented.
Let us revisit the IQ test
Both the stocks have an equal chance of falling by 7% from their current levels. After all a 93% chance of Stock B going up means it has a 7% (100-93%) chance of falling.

In case you chose Stock B, you are not very different from the average man on the street who prefers Stock B to Stock A just because it is presented in a manner that makes it appear more appealing.
As humans, we always make approximations in our decision making process. No wonder, we are all on the lookout for easy ways to make money. One of the approximations we do is to figure out departures from a base case described rather than calculate what is the eventual outcome.

So in this case, the description of Stock A's 7% chances of falling turns out to be the base case and the second option is evaluated against this. So a 93% chance of rising looks good for Stock B. The mind does not grasp the implications of a 7% fall and 93% rise in the first sweep!

In case you managed to get the above test right in one sweep, great show! But be sure to stay away from the many more that abound.  

Experience comprises illusions lost, rather than wisdom gained.
                                                                                - A French Parish Priest  
Investors are not as much "risk averse" as they are "loss averse".
Here is a desi version of classic example that the founding fathers of this discipline, Daniel Kahneman and Amos Tversky, presented to two groups of people.

Group I choice set
You have Rs1,000 in your pocket and need to choose between one of these two investing options
Option 1: A sure shot gain of Rs500
Option 2: A 50% chance to double the money and a 50% chance of making no profits
What would you choose?
Group II choice set
You have Rs1,000 in your pocket and need to choose between one of these two investing options
Option 1: A sure shot loss of Rs500
Option 2: A 50% chance of losing the Rs1,000 capital and a 50% chance of losing nothing!
Hmm! In their experiments they found that 84% in Group I chose option 1 whereas in Group II, a good 69% chose option 2!!

Know why the groups chose those options the way they did? It had to do with the way the options were posed to them. Group II participants had a sure shot loss staring at them as one option whereas the other option presented them an opportunity though half a chance to walk away with losing nothing.

Of course, the knowledgeable among you would have figured out that there is nothing to choose between the two options, as they are the same.

Hence, as long as the Sensex is climbing 400 points every month, a bullish trader will stomach a 100-point fall during a week and see it as a money-making opportunity. But when the Sensex is in a downtrend, even a 100-point rally during a week does not enthuse the traders enough!

In fact, empirical studies done in the USA prove the following: "Positive emotional value of a gain is only one-half to one-third of the negative emotional value of an dollar equivalent loss. For example, a $100 loss causes emotional pain two to three times the emotional pleasure of a $100 gain." This theory is called "Prospect Theory"?

Most people feel more pain for losing Rs100 than they feel happiness when they make Rs100.
Which portfolio would you prefer?
Portfolio A has Rs1,000 worth of one stock that appreciates by 10% and Rs1,000 worth of another stock that declines by 15%.
Or
Portfolio B has Rs1,000 worth of one stock that stays flat and Rs1,000 worth of another stock that declines by 5%.
There are similar studies done that demonstrate people prefer portfolio B to portfolio A.

Why?

Portfolio A has one stock that declines by 15% whereas the maximum decline of stock in Portfolio B is 5%. The mind ignores the fact that the other stock in Portfolio A appreciates by 10%. 

Hence, most people prefer Portfolio B to Portfolio A though both the portfolios lose the same.

Source: Sharekhan