Cognitively Yours 1.6

 

 

Raja R, Author

"To buy when others are despondently selling and sell when others are greedy, buying requires the greatest fortitude and pays the greatest reward" - Sir John Templeton

In the previous blogs, we discussed how mental shortcuts though needed to take quick decisions as well as fear of regret may also lead to biases which result in sub-optimal investment decisions. We had also discussed how impatience and need for instant gratification make us hardwired to short-term results. We also saw how we react to events and announcements on a stand-alone basis. In the last blog, we had seen how our predictions cannot be right all the time and we should accept error in order to reduce error and we can never be error-free in our predictions.

In this issue, we will begin with an interesting story instead of the statistical text book problems and relate it to our behaviour in investing.

“The Bottle Imp” is an 1891 short story by the Scottish author Robert Louis Stevenson usually found in the short story collection Island Nights' Entertainments. It was first published in the New York Herald (February–March 1891) and Black and White London (March–April 1891). In it, the protagonist buys a bottle with an imp inside that grants wishes. However, the bottle is cursed; if the holder dies bearing it, his or her soul is forfeit to hell.

Keawe, a poor Native Hawaiian, buys a strange unbreakable bottle from a sad, elderly gentleman who credits the bottle with his fortune. He promises that an imp residing in the bottle will also grant Keawe his every desire.

Of course, there is a catch. The bottle must be sold, for cash, at a loss, i.e. for less than its owner originally paid, and cannot be thrown or given away, or else it will magically return to him. All of these rules must be explained by each seller to each purchaser. If an owner of the bottle dies without having sold it in the prescribed manner, that person's soul will burn for eternity in Hell.

The bottle was said to have been brought to Earth by the Devil and first purchased by Prester John for millions; it was owned by Napoleon and Captain James Cook and accounted for their great successes. By the time of the story the price has diminished to $50.

Keawe buys the bottle and instantly tests it by wishing his money to be refunded, and by trying to sell it for more than he paid and abandoning it, to test if the story is true. When these all work as described, he realizes the bottle does indeed have unholy power. He wishes for his heart's desire: a big, fancy mansion on a landed estate, and finds his wish granted, but at a price: his beloved uncle and cousins have been killed in a boating accident, leaving Keawe sole heir to his uncle's fortune. Keawe is horrified, but uses the money to build his house. Having all he wants, and being happy, he explains the risks to a friend who buys the bottle from him.

Keawe lives a happy life, but there is something missing. Walking along the beach one night, he meets a beautiful woman, Kokua. They soon fall in love and become engaged. Keawe's happiness is shattered on the night of his betrothal, when he discovers that he has contracted the then-incurable disease of leprosy. He must give up his house and wife, and live in Kalaupapa—a remote community for lepers—unless he can recover the bottle and use it to cure himself.

Keawe begins this quest by attempting to track down the friend to whom he sold the bottle, but the friend has become suddenly wealthy and left Hawaii. Keawe traces the path of the bottle through many buyers and eventually finds a Haole of Beritania Street, Honolulu. The man of European ancestry has both good and bad news for Keawe: (a) he owns the bottle and is very willing to sell, but (b) he had only paid two cents for it. Therefore, if Keawe buys it, he will not be able to resell it.

Keawe decides to buy the bottle anyway, for the price of one cent, and indeed cures himself. Now, however, he is understandably despondent: how can he possibly enjoy life, knowing his doom? His wife mistakes his depression for regret at their marriage, and asks for a divorce. Keawe confesses to her his secret.

His wife suggests they sail, with the bottle, to Tahiti; on that archipelago the colonists of French Polynesia use centimes, a coin worth one fifth of an American cent. This offers a potential recourse for Keawe.

When they arrive, however, the suspicious natives will not touch the cursed bottle. Kokua determines to make a supreme sacrifice to save her husband from his fate. Since, however, she knows he would never sell the bottle to her knowingly, Kokua is forced to bribe an old sailor to buy the bottle for four centimes, with the understanding that she will secretly buy it back for three. Now Keawe is happy, but she carries the curse.

Keawe discovers what his wife has done, and resolves to sacrifice himself for her in the same manner. He arranges for a brutish boatswain to buy the bottle for two centimes, promising he will buy it back for one, thus sealing his doom. However, the drunken sailor refuses to part with it, and is unafraid of the prospect of Hell. "I reckon I'm going anyway" he says.

Keawe returns to his wife, both of them free from the curse, and the reader is encouraged to believe that they live happily ever after.

The story of Robert Louis Stevenson titled “The Bottle Imp” (full story available in the link) provides a different illustration of not looking beyond the immediate future and being myopic. The story tells of a genie in a bottle willing and able to satisfy your every wish and desire. You do have an opportunity to buy this bottle and its amazing denizen at a price of your choice. There is a serious limitation, however. When you’ve finished with the bottle, you have to sell it to someone else at a price strictly less than what you have paid for it. If you don’t sell it to someone for a lower price, you will lose everything and will suffer excruciating and unrelenting torment. What you would pay for such a bottle?

Certainly, you wouldn’t pay 1 cent because then you wouldn’t be able to sell it for a lower price. You wouldn’t pay 2 cents for it either since no one would buy it from you for 1 cent since everyone knows that it must be sold for a price less than the price at which it is bought. The same reasoning shows that you wouldn’t pay 3 cents for it since the person to whom you would have to sell it for 2 cents would object to buying it at that price since he wouldn’t be able to sell it for 1 cent. Likewise, for prices of 4 cents, 5 cents, 6 cents, and so on. We can by mathematical induction formalise this argument, which proves conclusively that you wouldn’t buy the bottle for any amount of money. The question is more than academic since in countless situations people prepare exclusively for near-term outcomes and don’t look very far ahead. They myopically discount the future at an absurdly steep rate.

We are able to appreciate the short sightedness in this story as the price is reducing and the final destination is a finite one. But, when we buy a stock which is continuously rising, we believe that it is possible to make money by buying stocks, whether they are or not overvalued, by selling them for a profit at a later date. This is because of the belief that there will always be someone (i.e a bigger or a greater fool) who is willing to pay a higher price. We tend to believe that the price increase will go for ever based on the recent upsurge of stock price and are wilfully blind to mean reversion.

“To buy when others are despondently selling and sell when others are greedy, buying requires the greatest fortitude and pays the greatest reward” - Sir John Templeton.

Story reference https://en.wikipedia.org/wiki/The_Bottle_Imp

"A Mathematician plays the stock market" by John Allen Paulos

Image credit https://unsplash.com/