Sunday, April 23, 2006

Behavioural Economics 101

I've always found the field of Behavioural Economics mighty fascinating. Here's enclosed some very interesting and practical applications of the same.

1. You decide to clean your car yourself to save paying the monthly 300 rupees to the car cleaner. Would you agree to clean your neighbour's car for the same 300 rupees?

2. You research a stock and you found it unworthy of a buy at 150 rupees. Today to same stock is at 1500 rupees, but is working to your buy calculations. Would you still buy it?

3. People tend to be "loss-averse" i.e. they experience more pain over a loss rather than pleasure over a gain. This is one reason why people are very uncomfortable selling stocks on which they are/have lost monies.

4. The principle of fairness is what differentiates the price you might pay for a bottle of soft-drink at a mom-and-pop store, as compared to a 4-star hotel. People feel it is fair for the 4-star hotel to charge 7-8 times more than the neighbourhood store. This is probably one reason why companies tend to lay-off people rather than reduce salaries during tough times.

5. You have a 100,000 rupees to invest in stocks. Since it's your first time, you'd invest 4000 rupees in the first month. You did a fine job of that and made a good 20% on that sum of money. The second month, you put in another 4000 and lo behold! another 22% return after month 2. ... notice that in the third month, your investible amount would have increased from 4000 to perhaps a 12000 rupees. This "mental accounting" allows people to take more risks when a string of success reaches you.

6. Often, cab and auto drivers tend to stop working for the day when they have reached their targeted income for the day. So they nonsensically, work shorter hours on rainy days and work longer hours when fares are scarce. In context, they forego an opportunity to earn more on "make-hay-while-it-shines" days. On the investing front, day-traders are like the cab drivers. The author goes on to suggest that investors should be allowed to look at their portfolio only once in 5 years.

7. The use of incentives (cue) is another factor that determines behaviour. In Ireland, a small charge (15p) was levied on plastic shopping bags. Since then, most people carry their own shopping bag to save some money. On the other hand, when in Israel a nursery imposed a fine for parents who arrived late to pick-up their children ... the response was that parents arrived more late than ever. Reason - by making the payment, the parent no longer felt guilty (in other words, they have cleaned their conscience) ... this is a great illustration of how behaviour is often different in different situation though the premise is similar.

8. Most people crib on the taxes charged by the government on one's incomes but then tax deducted at source doesn't exhibit a more mellowed emotion. Similar instances ... annual performance evaluation by companies is a hot-bed for politics, prejudice often leading to attrition of "dis-satisfied with evaluation (and not necessarily non-performing)" employees.

Behavioural Economics is a fast growing field in research and study. Why not ... people are prone to error, irrationality and emotion, and they act in ways not always consistent with maximizing their own financial well being.

> Behavioural economics: seven principles for policy-makers
> Exuberance is rational (The NY Times Magazine)
This was however one instance I didn't agree to in the article. It says: A team is trailing by 2 pts in a basketball match. With 3 seconds to go and the ball with them, should they go for a 2 pt - which will tie the game and take it to overtime OR, should they go in for a 3. A 2-pointer has a 50% chance of going in, while a 3-pointer has a 33% chance of winning it. The author feels coaches often go for 2 pts as it lowers the risk of sudden loss. ... this is where I disagree because when I go in for a 2-pointer and then my chances at OT (which is again a 50:50 chance) .. I have never ever moved below a 50% chance of a victory. However, going in for a 3-pointer would give my team only a 33% chance for a victory.


Blogger Shankar said...

Discrimination co-efficient in people behaviour - I know of atleast one US company that moved away from sourcing PCs from IBM after Lenovo took over. It's new vendor for worldwide PC requirements is Dell, which is a tad over-priced from the previous deal.

I've seen how much more respect a wealth client gives to a Regional Sales Manager once the word "Sales" is removed from his/her title.

There are n such examples in business and beyond ... how behaviour is governed by things around us.

3:51 PM  
Blogger Rohit said...

i wanted your opinion on these shipping stocks.....
Varun Shipping (have 250 shares),
Mercator Lines (have 500 shares)


7:59 AM  
Anonymous Anonymous said...

Hi Shankar,

I was looking at Satyam as a long term investment and found some contrasting data.

1. As per this link :

Its 2005-06 EPS is 30.50 and there guidance for 2006-07 is 36 Rs EPS.
But BSE/NSE suggests that its EPS is 38.51

Can you please provide your views on this ?

What do you think is it a good bat at CMP 759 Rs (It came down from 850 levels) or should I still wait for it to come down ?

Supal Patel

4:38 PM  
Anonymous Anonymous said...

Hi Shankar,

What is your view on Hero Honda?

I found below mentioned positives :

1. Its growing consistantly. (Sales grew avg. 25% in last 3 yrs)
2. Its trading cheaper then its peers. Its current P/E is 20.5 (Bajaj Auto P/E 30 and TVS Motors 30 P/E)
3. Great dividend track record.

What do you say ? Is it a buy ?


Supal Patel

4:54 PM  
Blogger Shankar said...

[1] Varun Shipping closed the yr at an EPS of 10.85, thereby at a PE of 7.8 ... a bit higher than it's peers. KR Choksey has given a buy on this counter with a target price of 130 rupees. The dividend yeild is impressive.

Unbelievably, it's 2nd largest mid size LPG vessel operator in the world. So hold onto Varun.

[2] Mercator - this is becoming a worry, aint it? Excellent PE of 4.95 and has been a steady performer. .. again hold.

9:13 PM  
Blogger Shankar said...

Hi Supal,

Thanks for the link. Satyam is a definite buy. With the numbers thrown in the article, I feel much better as I had done my calculations on a conservative EPS of 29 rupees per share.

Hero Honda is on my "buy-when-you-have-money" list (kinda broke for now). The stock has a PE of just 14.5 .. has tremendous growth, excellent management (i had the opportunity to meet Mr. Brijbhushan Munjal once), superior practices. Buy !!!

Warm Rgds

9:27 PM  
Blogger Shankar said...

Supal ... wait !! HHML has been given an underweight rating by Morgan Stanley.

9:57 PM  
Anonymous Anonymous said...

Hello Sir,

I got to read about bhagyanagar metals in one of your prvious blogs.At todays rate of 60 is it still a buy.


1:53 PM  
Blogger Shankar said...

Hi Anil,

Bhagyanagar Metals at 60 rupees is at a fwdPE of 8.76. Thats a fairly valued stock. You can play a short term roll here ... put in a sum of money but define a stop-loss say 55 rupees.

Warm Rgds

2:20 PM  
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