Cognitively Yours 1.8

Raja R, Author

"Investors must learn to treat even the gains from stock markets as a part of their own hard earned wealth and not as a windfall income"

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. We had seen how our predictions cannot be right all the times and we should accept error in order to reduce errors and we can never be error free in our predictions. We also saw with the help of a story, how we prepare for near-term outcomes and do not venture to look far-ahead. In the last one, we saw that as emotional travel is not our forte and we cannot predict how we will behave in future in the heat of the moment, pre-commitment and planning helps us in investment.

In this blog, let us begin with an interesting story “The man in the Green Bathrobe”.

A couple go to Las Vegas on honeymoon. By the third day of their honeymoon in Las Vegas, the newlyweds had lost their $1,000 gambling allowance. That night in bed, the groom noticed a glowing object on the dresser. Upon inspection, he realised it was a $5 chip they had saved as a souvenir. Strangely, the number 17 was flashing on the chip’s face. Taking this as an omen, he donned his green bathrobe and rushed down to the roulette tables, where he placed the $5 chip on the square marked 17. Sure enough, the ball hit 17 and the 35-to-1 bet paid $175. He let his winnings ride, and once again the little ball landed on 17, paying $6,125. And so it went, until the lucky groom was about to wager $7.5 million. Unfortunately, the floor manager intervened, claiming that the casino didn’t have the money to pay should 17 hit again.

Undaunted, the groom took a taxi to a better-financed casino downtown. Once again he bet it all on 17 – and once again it hit, paying more than $262 million. Ecstatic, he let his millions ride – only to lose it all when the ball fell on 18. With no money for a taxi, the groom walked the several miles back to his hotel.

“Where were you?” asked his bride as he entered their room.
“Playing roulette….”
“How did you do?”
“Not bad. I lost five dollars.”

What “error” did the man in the green bathrobe make, when thinking about his winnings (and ultimate loss)? - He did not “update his reference point” for wealth with each win.

He felt that the money he had won was not really his (in some way, it still belonged to the casino – i.e., the “house”), and therefore it meant less to him  had he “earned” the money. Hence, he was more willing to gamble with the winnings.

In reality, of course, the winnings were just as much his as if he had earned them over decades of hard work, and he should have perceived them as such, rather than viewing them as somehow less valuable. A person who has paid $10 for a ticket to a movie is less likely to pay for another ticket, if he or she loses it than a person who loses $10 on the way to purchase the movie ticket is to cough-up an additional $10 to buy the ticket in the first place. Why is this the case you might ask? It is because you assign a value of $20 to the movie in one scenario, where as your write-off the first $10 and assign a $10 cost to the ticket in the second scenario.

How this is reflected in our investment behavior? Do we also treat gains from a stock as different from the price of the stock? Suppose you buys a stock at $100. The stock’s price goes up to say $150 within a week of purchase. Later, it corrects and slips to $120. More than regret, you will be happy as the reference point is $100 and you are happy that your investment has appreciated, agnostic to the fact that you could have made a profit of $50 had you sold it when its price was $150. Imagine the other scenario - You have bought the stock at $150 and stock price falls to $120. There will be regret as your reference point is $150 and not $100, as in the earlier case.

Investors derive gains from gain and losses of wealth rather than from the absolute level of wealth. In investment, we do distinguish between the gains from the investment and our investment, which we treat as earned money. This is very much evident in investors choosing to invest periodically. If their earlier investments have given decent returns, they do not mind if their later investments do not do well as they do have gains to cushion the losses. However, if the markets continue to fall and their entire gains are extinguished, they become risk averse.

Investors must learn to treat even the gains from stock markets as a part of their own hard earned wealth and not as a windfall income. The current gains in the market are a reward for waiting without gains for long years and bearing the risk of uncertainty of the markets.

Photo by Adi Coco on Unsplash

Reference: "A mathematician plays the stock market" by John Allen Paulos