Friday, 18 September, 2009

Commitment and loss aversion

Commitment & Loss Aversion

I recently received the excerpts from the book "Sway" given at the bottom of this page through email. I remember having seen it some time back on the web. Can't recall the source.

However, the stuff is quite interesting in the realm of behavioural finance.

After reading it, we must understand the following:

  • Money earned from Salary, Received as a gift, Won in a lottery, Obtained by providing services, Got from capital gains by selling shares - All of it is of the same value in monetary terms. For instance, just because it is money from "hard-earned" salary, it should not be preserved more carefully. Likewise, just because it is earned from an "easy" source like a gift or in a lottery must not be frittered away.
  • When your portfolio value (or the share price of one of your holdings) increases - for any reason whatsoever, you must ensure that you make all efforts to "preserve" the profits and should not treat a reduction in value as being acceptable merely because it is still higher than your original purchase price
  • In a similar vein, when your portfolio value (or the share price of one of your holdings) decreases - for any reason whatsoever, you must ensure that you do not allow your emotions to either
    • "wait till it regains its original value to get out" and keep increasing your de-facto losses (because you know that some of those scrips will never get back to their original prices) - You must just get the hell out by cutting your losses and move on to better securities
    • "Get the hell out of the scrip as soon as it comes back to your purchase price or thereabouts" (Despite knowing that it is indeed a blue chip and you've already borne the pain of the temporary downturn and you're perhaps likely to reap the rewards of your patience because the business cycle has turned positive)
    • And you must know the difference between the above two categories - After all, you need to know the difference between your "core portfolio" - the "hold for the long term scrips" and the "trading scrips - use the momentum, flavour of the season and get in and get out quickly categories"



Commitment & Loss Aversion

In a great book "Sway", the authors, Ori Brafman and Rom Brafman, write on commitment and loss aversion.


"We've all experienced the pervasive pull of commitment in some form or another; whether we've invested our time and money in a particular project or poured our energy into a doomed relationship, it's difficult to let go even when things clearly aren't working. As difficult as it can be to ad­mit defeat, however, staying the course simply because of a past commitment hurts us in the long run.


Independently, each of these two forces-commitment and aversion to loss-has a powerful effect on us. But when the two forces combine, it becomes that much harder to break free and do something different.


It's precisely because of the compounding effect of these two forces that students in Max Bazerman's negotiations class at Harvard Business School would do well to hold on to their wallets when he introduces his "twenty-dollar auc­tion." They say it's easy to take candy from a baby; Professor Bazerman has found that it's just as easy to take money from Harvard MBAs.


On the first day of class, Professor Bazerman announces a game that seems innocuous enough. Waving a twenty-dollar bill in the air, he offers it up for auction.


Everybody is free to bid; there are only two rules. The first is that bids are to be made in $1 increments. The second rule is a little trickier. The winner of the auction, of course, wins the bill. But the runner-up must still honor his or her bid, while receiving nothing in return. In other words, this is a situation where second best finishes last.


Indeed, at the beginning of the auction, as people sniff out an opportunity to get a $20 bill for a bargain, the hands quickly shoot up, and the auction is officially under way. A flurry of bids follows. As Bazerman described it, "The pat­tern is always the same. The bidding starts out fast and furi­ous until it reaches the $12 to $16 range."


At this point, it becomes clear to each of the participants that he or she isn't the only one with the brilliant idea of winning the twenty bucks for cheap. There is a collective hard swallow. As if sensing the floodwaters rising, the stu­dents get jittery. "Everyone except the two highest bidders drops out of the auction," Bazerman explained.


Without realizing it, the two students with the highest bids get locked in. "One bidder has bid $16 and the other has bid $17," Bazerman said. "The $16 bidder must either bid $18 or suffer a $16 loss." Up to this point the students were looking to make a quick dollar; now neither one wants to be the sucker who paid good money for nothing. This is when the students adopt the equivalent of football's war-of­-attrition model. They become committed to the strategy of playing not to lose.


Like a runaway train, the auction continues, with the bid­ding going up past $18, $19, and $20. As the price climbs higher, the other students don't know whether to watch or cover their eyes. "Of course," reflected Bazerman, "the rest of the group roars with laughter when the bidding goes over $20."


From a rational perspective, the obvious decision would be for the bidders to accept their losses and stop the auction be­fore it spins even further out of control. But that's easier said than done. Students are pulled by both the momentum of the auction and the looming loss if they back down-a loss that is growing greater by the bid. The two forces, in turn, feed off each other: commitment to a chosen path inspires additional bids, driving the price up, making the potential loss loom even larger.


And so students continue bidding: $21, $22, $23, $50, $100, up to a record $204. Over the years that Bazerman has conducted the experiment, he has never lost a penny (he donates all proceeds to charity). Regardless of who the bidders have been-college students or business executives attend­ing a seminar-they are always swayed.


The deeper the hole they dig themselves into, the more they continue to dig."

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