New Year Resolutions: How to keep 'em for good!

Time passes by quickly and rapidly, and it's another new year again. It's the time when (almost) everyone starts worrying about new year resolutions: some of us might be thinking of reducing waistline, others might plan to kick their smoking habit (actually, many do it and they do it very often), some might want to save more money this year, others would like to become a better human being (usually in case they could not come up with any concrete new year resolutions)! All said and done, majority of us may admit that our new year resolutions fizzle out by the end of January, or may be in many instances, by the end of the first week of the year itself. This is a problem we face almost every year (by the way, why bother about new year resolution, it happens with almost all goals we set, for that matter). So, let's talk about how to deal with this problem of ours: How to stick to our new year resolutions?

Well, I am not gonna give you any short-cuts to help you make and subsequently stick to your new year goals. Rather, in this blog post, I try to summarize some five simple ideas that I might use to make sure that I don't deviate from my new year resolutions, if I make any.

Image source: Getty Images

First and foremost, following what all preachers suggest, I would also go for making a plan, or say list of goals. The list should not be a virtual one, but in black-and-white. Writing down my goals and plans implies that I commit myself to those goals. And it is scientifically proven that committing yourself firmly by explicitly writing down your intentions increases preventing screening rate. In an earlier post, I reviewed an article published in Nature, that talks about how predetermined shopping list helps people stick to a healthy shopping habit. In a similar fashion, when we have our resolutions written, the chances of getting it through are higher than otherwise. So, let's write down our resolutions, right now (only if you have any)!

Of course, one important aspect of setting goals or making new year resolutions is: it should be specific and achievable. We all know our strengths and weaknesses, as well as how much we can take on. On our list should include the most important things that we want to accomplish this year. Be precise; don't generalize. For example, if I want to loose weight, I cannot vaguely write my goal as "To loose weight". It would be more effective if I plan as to how much weight I want to loose in how much time frame and in what ways such as jogging 2 extra kilometers or hitting the gym thrice a week, and so on. Also, it should be within our capabilities. I cannot set a goal of saving half of my salary (if presently I end up borrowing from friends and relatives to survive). Be rational in setting up goals.

Thirdly, reward yourself for avoiding any temptation while sticking on to the task. This is something what noted psychologist and behavioral economist Duke Professor Dan Ariely calls reward substitution in his book The Upside of Irrationality. It may also be referred to in the context of bundling of temptations. What it essentially means is we tend to motivate ourselves to do some otherwise difficult-to-take-up tasks by way of rewarding ourselves. For example, I love to listen to music, but due to some reasons or the other, I didn't get to enjoy music very often. Also, like most of lazy asses, I also prefer resting on the couch to jogging. To overcome this problem of duality, I adopted this strategy of bundling the temptations of listening to music with hitting the road for jogging. Now I can enjoy my favorite music for at least forty five minutes straight while I jog in the evening. Well, this strategy serves the purpose for most of our otherwise-difficult-to-start tasks, and that is for sure. The once catch is that you need to look for the right temptation.

Image source: Getty Images

Like rewarding ourselves keeps us on track towards working for our goals, punishment does do its bit. This punishment need not be literal one. As Richard Wiseman from University of Bristol suggests, it is completely natural to revert back to our old habits from time to time, hence treat any failure as a temporary setback, but don't make them as an excuse to give up altogether. At the same time, think of some punishment, even virtual, for your every failure. This fear, even small, of punishment might keep you focused on your goals. As some behavioral economists founded a website called stickK.com, where you can link your bank account and set your goals. You can arrange to forfeit money if you don't achieve your goals. This money can go to a charity you hate most, or to your friend's account, and so forth. This strategy of financial (dis-)incentives can make your plan effectively on track. You can improvise this strategy by giving a sum of money to your friend/spouse saying that if you fail to achieve a certain goal within a given time frame, (s)he can keep the money that you gave, thereby making sure you still work for your goals.

Finally, find someone who can kinda mentor you through the odds of achieving the goals. This becomes more important if the goal requires some specific pedigree. In an article published in the Annals of Internal Medicine, it was found that achieving goals become easier with the help of a mentor. So, seek social support to achieve your goals. Richard Wiseman also suggests that we should share our goals with our friends and family. By doing so, we feel the fear of failure and consequently working more sincerely for our goals, but at the same time, it gives us motivation in terms of eliciting support from them in case we are able to achieve our goals. Another reward... huh!

These are some of the ideas that I feel might keep us stick to our new year goals. Well, obviously there could be lot more, and you can find articles written on this subject here, here, here, and here.

If you haven't happened to chalk out your new year resolutions yet, fearing that your last year's new year resolutions got burst right after you overcame the hangover of new year party, then it's time to write down and share your new new year resolutions. Cheers!

[Review] Nudge Yourself with a Pre-committed Shopping List and Stay Healthier

Behavioral economists have for long been studying about how to exploit people's behavioral tendencies to nudge them take such decisions which are in best of their interest, even if not in short term, definitely in long term. Health economics is one of such areas that researchers in behavioral economics are exploring in terms of practically relevant issues with great curiosity. I recently happened to read a paper titled "The cost-effectiveness of shopping to a predetermined grocery list to reduce overweight and obesity" authored by Nicole Au, G. Marsden, D. Mortimer, and P. K. Lorgelly, published in Nature's Nutrition & Diabetes journal. In this post, I am reviewing the same article with my personal observations and comments. Hope you find it interesting to read.

The study examines whether pre-commitment strategies such as shopping according to a shopping/grocery list (prepared in advance) is likely to be cost-effective and result in benefits such as facilitating healthier diets, weight loss, and ultimately better health among those who are over-weighted and suffering from obesity. The issue has been a serious one especially among the urban population irrespective of geographical boundaries, and the researchers at the Centre for Health Economics at Monash University, Melbourne (Australia) have investigated the issue from the perspective of behavioral economics which seeks to answer why and how people behave in a certain way and how their behavior can be modeled using their own behavioral tendencies and habits as nudge. These nudging strategies can be used to help people make choices that are healthier and more beneficial to their lifestyle.

The researchers say, "And the good thing is some of these behavioral economic strategies can often be carried out at very low costs. Encouraging these strategies in the community could also be a cost-effective policy option for the governments."

Image source: bbc.co.uk

When we commit to a shopping list (prepared in advance) to buy only the stuff we actually need, it help us avoid the temptations of purchasing unhealthy food items, apart from spending money on (sort of) unnecessary purchases. The experimental evidence suggests that such habits lead the individual bring out meaningful impact on weight loss and long-term health, particularly among overweight and obese individuals.

The authors say that the advance planning of shopping list is a really cost-effective tool to lose weight when compared to the alternative of 'doing nothing', and moreover it does improve quality of life, both in terms of irrational habits leading to unhealthier decisions and unwarranted monetary loss.

Dr. Nicole Au also adds that diet is just one side of energy equation and that "there is a great potential for behavioral economic strategies to improve physical activity as well as diet, and future work is needed to investigate whether such strategies are cost-effective."

It is unarguably acceptable proposition that pre-commitment strategies can be effective interventions for facilitating healthier diets and also for promoting weight loss among overweight and obese individuals.  However, the issue whether the incremental weight loss arising from shopping to a pre-commitment intervention tool is small yet significant. We all may agree that the long-term effects of such decision habits are definitely significantly large in various contexts, including health and financial aspects.

Image source: Literacy Revelation (Blog)

According to the study, a pre-commitment strategy to alter the home food environment is a cost-effective means for maintaining healthier life style. For instance, in Indian context, people tend to drop in to shopping malls and superstores without any pre-commitment intervention tool (i.e. shopping/grocery list) and end up buying unnecessary food items (many time other stuff too that they later regret buying of)  involving financial implications and health implications (just a little later when they will have to consume those unhealthy purchases in order to derive utility from the money they spent on buying those things).

It is very much oblivious that many consumers understand all too well of those unhealthier purchases but they suffer from impulsiveness (which the marketers prefer to to call strategies to generate impulsive buying) and poor self-control that they behave in a manner that depart from a rational (or even, quasi rational) decisions that are in their good intentions.

Okay! Enough of Gyan! Now I better go prepare my shopping list for this weekend. You too think about the same or else you may continue reading some more blog posts of mine. ;)

Happy Rational Learning!

The study, recently published in Nutrition and Diabetes, looked at whether pre-commitment strategies such as shopping according to a grocery list were likely to be cost-effective in facilitating healthier diets, weight loss, and ultimately better health among overweight and obese individuals. - See more at: http://www.thefiscaltimes.com/Articles/2013/09/12/Hidden-Power-Grocery-List#sthash.8bozXie7.dpuf

The study, recently published in Nutrition and Diabetes, looked at whether pre-commitment strategies such as shopping according to a grocery list were likely to be cost-effective in facilitating healthier diets, weight loss, and ultimately better health among overweight and obese individuals. - See more at: http://www.thefiscaltimes.com/Articles/2013/09/12/Hidden-Power-Grocery-List#sthash.8bozXie7.dpuf

The study, recently published in Nutrition and Diabetes, looked at whether pre-commitment strategies such as shopping according to a grocery list were likely to be cost-effective in facilitating healthier diets, weight loss, and ultimately better health among overweight and obese individuals. - See more at: http://www.thefiscaltimes.com/Articles/2013/09/12/Hidden-Power-Grocery-List#sthash.8bozXie7.dpuf

[Interesting Readings] Dr. Raghuram Rajan Takes Charge of RBI, India's Central Bank

When Indian economy is struggling to achieve a growth of 4.5%-5% for this fiscal year (please note that it was 8% to 9% a few years ago), its foreign currency reserve (predominantly measured in terms of USD) is just enough to manage its foreign trades for about six months or so ($247, 402 Million as on 30 August, 2013; Source: Database on Indian Economy, RBI), its domestic currency Rupee (₹) is depreciating against US Dollar, including other hard currencies such as Pound Sterling and Euro, very swiftly (Rs.66.04/US$ as on 5 September, 2013), and foreign capital flows into its stock market is staggering (FIIs have been net sellers for past few weeks in a row, however, at the time of writing this article, some positive signs were observed, FIIs being net buyers with ₹800.71 Crore as on 6 September, 2013; I'll come to this point a li'l later), a University of Chicago's Booth School of Business Professor Dr. Raghuram Rajan has taken charge as the new Governor of the Reserve Bank of India (RBI), India's central bank. There has been positive news and reactions from all the corners about the suitability of the IIT Delhi-IIM Ahmedabad-MIT educated economist Dr. Rajan for this post in these tough times that India is witnessing. Dr. Rajan holds a rockstar appeal and has attracted lot of media attraction. Through this post of mine, I am trying to summarize what has been written about him across media reports (of course the list of articles/coverage is limited to what I could get access to; there could be several reports that I might have missed meanwhile).

Image courtesy: TheHinduBusinessLine.com

Dr. Rajan, who is the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago's Booth School of Business has been a proven track record as an economist. NDTV Profit crisply talks about 10 things to know about the new RBI Governor. It says about the economist-turned-banker that:

"This will be Mr. (sic.) Rajan's second assignment in the country. He was appointed the Chief Economic Adviser to the Finance Ministry last year... [He] was the Chief Economic Counselor and Director of Research (simply put, the Chief Economist) at the International Monetary Fund from September 2003 till January 2007."

His 2005 paper titled "Has Financial Development Made the World Riskier?" presented at the Fed conference at Jackson Hole, Wyoming, had attracted ire of the equals of (Alen) Greenspan and (Lawrence) Summers. This paper also used as a base for the 2010-documentary titled Inside Job which shows the Global Financial Meltdown. In his book, Fault Lines: How Hidden Fractures Still Threaten the World Economy, he talks about the hard choices that all economies must make to ensure greater stability and lasting prosperity. With respect to India's recent growth stories and successes, he argues that the country must act decisively to maintain its people-oriented growth. This unique development path, he outlines, will be a compelling role model for developing economies - a triumph of rapid growth in a flourishing democracy.

Well, on the day when the appointment of Dr. Rajan as next RBI Governor was announced, the Economic Times publishes the cover story with the headline "Rajan on a High, Re at a Low", as Rupee was trading against US Dollar at an all-time low level of 61.77. Dr. Rajan has the potential to transform India's fortune, Simon Flint writes in the Economic Times' Opinion  piece. There is no doubt about it, but wait a minute!

There was euphoria all around the proposed appointment of Dr. Rajan, when Swaminathan S. A. Iyer wrote in his column in the Economic Times, "...by trying to do so many things at once (working on inflation, exchange rates, and growth), RBI risks doing none of them well... Will Rajan put this vision into practice as RBI Governor? Not a chance. Indian politics will not permit an inflation-only focus for RBI. After his spell in the finance ministry (as the Chief Economic Adviser), Rajan must be well aware of the limits to the independence of any RBI Governor." Quite true...huh!

Adding to the issue is an opinion by Vivek Kaul that Dr. Rajan is not an instant coffee. He also cautions in First Post article on why Raghuram Rajan is not Amitabh Bacchan whose presence will solve all the problem, precisely there is nothing like "Aaya Toofan, Bhaaga Shaitaan".

On the day of taking charge, the good senses prevail across the market, economy and among the people. Financial Times reports the story as Rajan Enters RBI with a Big Bang, and mentions that, "A big package of financial sector reforms has been launched by India's high-profile new central bank chief as the country battles a currency crisis and slowdown in economic growth... He won a reputation as an economist for having warned of the financial crisis that precipitated the global crisis in 2008, but cautioned this week that there was no magic wand for India."

In the story titled India's New Central Bank Governor Seeks to Calm Investors, the Wall Street Journal writes, "India's new central bank governor announced fresh steps to stabilize the country's beleaguered currency and outlined an ambitious plan to shake up the country's conservative banking system... [He] also sought to reassure investors unnerved by the turmoil in local markets by emphasizing the importance of transparency and consistency in the central bank's actions."

Image courtesy: FinancialExpress.com

The speech (full text of which can be accessed here, here, and here) made by Dr. Rajan on the first day of his appointment does magic to the market sentiments, as the markets showed some signs of recovery, even for short time. Sensex on that day gave a 370-point salute to the new RBI chief. As on 6 September, Rupee comes back at ~65 per US Dollar and the Sensex gained over 1,000 points in last three trading sessions.

Also read: Seven Steps by Rajan that Propelled Sensex above 19000 and Raghuram Rajan's rupee gamble may help lure $30 billion.

In a story, NDTV Profit explains 10 reasons why markets are cheering Raghuram Rajan. To quote from the story, "...Analysts said they had expected the 50-year-old academic and celebrated economist to do his homework, but had not expected him to detail so comprehensive a plan in his first statement. The Reserve Bank of India under Raghuram Rajan has made an impressive start, global brokerage Nomura said."

One of the most interesting stories on Dr. Rajan's appointment as RBI governor is the one by The Economist. The story titled Into The Pressure Cooker, questions his credibility as a banker since he is not a specialist in monetary policy, has worked more on free-market persuasion, including worries about unintended consequences of regulation. As the article goes on to talk, "...[He] knows the ultimate solution for the droopy rupee is government action to address a weak manufacturing base, dodgy fiscal policy and sky-high gold-imports."

The WSJ piece also noted that Dr. Rajan will have to face issues with respect to the RBI's independence. Take the new banking licence issue for instance. Since the government wants the RBI to give bank licence to well-connected tycoons; he, sensibly, opposes this and wants more small banks to be created. Rightly put, India is lucky that Mr. Rajan is in the RBI job. He will be bulwark against populism and an advocate of liberalization. But his hardest task is to avoid being labelled a saviour. The country's economic future is largely in the hands of its government, not its central bank. When a minister next calls, he should remind them of that.

So far so good. All eyes are on the new RBI's governor. What would he take his next call about? As FT story says "[he] will make his first substantial statement on monetary policies in two weeks (on 20 September 2013, when mid-quarter monetary policy review is due.) Let's wait and watch! Meanwhile, let us wish him good luck as Rajan has the pluck, he also needs some luck...

The Blue Focus Effect

To solve the problems of today, we must focus on tomorrow.

 - Erik Nupponen

It has been so long since I’ve got something to post here. It’s not that I haven’t got any interesting stuff to write about; rather I was overloaded with the ideas to discuss here. Just that I was preoccupied with some other academic assignments. Now when I’m finally here, let’s start with a simple exercise as follows:

1. Take a good look all around you and try and notice everything that is brown. Really try and memorize everything you see that is brown, whether it be dark or light shades of brown.
2. In a moment, without peeking, close your eyes and try to remember everything you saw… that was blue!

This is tricky, isn’t it? Most people are stumped. Actually, we are so focused on the brown things that we hardly notice anything that is blue. This is what psychologists prefer to call the blue focus effect. We sometimes allow ourselves to get so focused on the negative things in our lives (the brown) that we don’t notice any of the positive things (the blue).

I was just wondering if individual/small investors also behave in a similar way. I’m trying to get detailed account of some individuals who would have behaved similarly. I’ll try to put it down here once I’m through with gathering relevant information. Keep watching this space. Till then... Happy Investing!

5 Reasons to Know Why Wealth Maximization is not an Investor’s Ultimate Goal?

It is believed that an investor wants to make money out of investing in financial assets. They tend to realize the goal of wealth maximization from their investments. Their investment decision making is in line with the classic economic theory of utility maximization. But what they fail to realize that they are human being and are bound to make mistakes that might stray them from their investment goals.

Image source: http://www.outofmygod.com

Most models in economics and finance assume that investors are completely rational and that the market is efficient. With these two assumptions, one can develop models that derive equilibrium prices of risky assets, the prices of a unit of risk, the risk premium, the risk-return relationship and so on. Research in applied finance and economics has provided enough evidence that the market is inefficient and that investors are only “semi-rational”, while semi-rationality means that that investors make systematic errors while making their investment decisions. Given the certainty that investors make systematic errors, it seems quite logical that wealth maximization is not the ultimate goal of investment decision making. Following are the five reasons explaining their semi-rational approach to investment decision making, leading to erroneous investment goal:

(i)         Investors ignore in their investment decision-making process the correlation of rates of return on various assets. They don’t see the relationship between two or more different assets return following a similar trend.

(ii)       Decision weights, w(p) – subjective probabilities – are used instead of the true probabilities, p. Investors assign weights to past rates of return even though such rates of return may be irrelevant. Thus, even when the investors are told that the market is efficient and rates of return follow a random pattern, they form their belief based on assets past return.

(iii)           Investors make investment decisions based on the change of wealth, x, rather than the total wealth, w+x, where w is the initial wealth and x is the change in wealth. They perceive each of their investment in the portfolio in relative terms, rather than absolute terms. This approach gives them half the picture of their investments, and they tend to make faulty investment decisions.

(iv)          Individuals in general and investors in particular have “mental department” – also known as mental accounts – (i.e. they make several accounts in their minds, which implies that the aggregate wealth maximization is not the goal of their investment decision making.) Suppose an investor has a portfolio of P₀ value at time t₀, where P₀ consists of a certain portion of equity E₀, and remaining as debt instrument D₀. Essentially, P₀=E₀+D₀. If at time t₁, the portfolio becomes P₁=E₁+D₁, where P₁>P₀, E₁<E₀ and D₁>D₀. He fails to take into account the overall increase in the value of the portfolio; instead he might get panic and make a financial fatal decision.

(v)     In a nutshell, under certain conditions, investors’ deviation from rationality is important in determining asset prices and market dynamics. Literature has already provided sufficient evidence about this phenomenon of irrational or semi-rational behavior of investors and its relationship with asset prices and returns. There is ample support for this theory of investors being non-rational in investment decision making.

So, what if I’m irrational?

This post of mine starts with a simple question: Are you irrational?

What is your take on it? You think you’re rational. Or, you’re not sure of being either. And why so?

Well, for those who feel unsure about the term ‘irrationality’, let me suggest some explanation. Wikipedia describes irrationality as “an action or opinion given through inadequate reasoning, emotional distress, or cognitive deficiency”. It is understood that economic definition of rationality and irrationality will vary according to the context it is used in. But, in general, irrationality refers to the state of being irrational – the opposite of being rational – when people lack the power of understanding, either full or in part, and fail to decide according to ‘the economic theory of utility maximization’.

Research on the issue of irrationality observes that people tend to be continuously irrational, at the same time claim to be perfectly rational. Strange!! No? I’ll further take up some contextual examples wherein people intentionally behave in irrational manner, but argue (with others or with themselves) that their actions are rational, also otherwise.

First example which I pick to quote here is related to a very much trending issue: Team Anna Hazare and its anti-corruption movement. This anti-graft crusader led by Sri Anna Hazare has gathered enormous supports from the masses; of course, it has attracted critics also, but very less when compared. People are coming from almost every nook and corner to their nearest protest points to extend their support to the movement. There are two issues which explain their behavior at this moment. First, their actual belief differs from what they perceive to believe, known as delusions. They do know that any severe issue such as corruption is not going to vanish or even controlled just by passing of the Jan Lokpal Bill or whatever; still they are herding in one sense or the other; most of them are doing what their neighbor is doing. And you remember my last post where I tried to explain how our neighbor’s actions affect our own behavior and actions also. Don’t feel like I am against extending support to the cause, on the contrary, I am a strong supporter to the movement. I am just explaining the behavior of majority of them, including that of mine! My question is: Do you feel you won’t give away bribe for a small service such as getting a berth in railways and go on to make a complaint to the Lokpal or any such agent? In this context, I believe that making paying bribery legal as suggested by the chief economic advisor Kaushik Basu in his working paper for Ministry of Finance (Govt. of India) and supported by NR Narayana Murthy, seem more rational. Yet, these irrational behaviors are justified to great extent, aren’t they?

Another example is concerned with my core area of interest, finance, economics and investments. Human behavior works within a mechanism that has evolved to give optimal behavior in normal conditions leading to irrational behavior in abnormal conditions. Once in situations outside one’s comfort zone (this may again vary depending on one’s life cycle, demography, and other host of factors), people often experience intense level of odd behavior – either fear or greed – and tend to regress to a fight-or-flight-response mentality. You may encounter a number of individuals who show this type of behavior in stock market. Investors get panic on (sometimes entirely) irrelevant piece of information and commit financially fatal mistakes. Their irrational response to such situations is reflected in their trading decisions, which subsequently boomerangs and this process continues to create some sort of market bubbles. Ultimately, investors end up losing their fortunes. This may be called the negative side of irrationality. Now, let’s look into the positive sides of irrationality, if any. For instance, you along with your friend go out for a lunch at some place where we are most unlikely to visit again. You notice that your friend leaves the waiter a tip. You might be thinking, “How irrational! He is not going to see the waiter and the restaurant again, so why leave him a tip?” So, is it really irrational to tip? Even if, it is, it is good to do that – both economically and socially! Similarly, in stock markets, going against the prevailing trends might seem irrational at that moment, but afterwards, it may take either course: favourable or unfavorable. If favourable, you would pat yourself that you’re wiser than others and earn yourself a good reward for that. If your odd decision goes wrong, you are most likely to say that you might be suffering from behavioral biases leading to a wrong decision and a subsequent loss. Your one time rational behavior (as it was perceived then) becomes entirely irrational after the outcome changes.

Being irrational sometimes lead to favourable outcomes and vice versa. For me, therefore, a person is rational if he exhibits a goal-directed behavior and tries to achieve this goal in the best possible way, given his constraints. “Goal” and “best possible way” are, of course, specific to the context. Often, our inability to comprehend the consequences of our own actions, possibly due in part to lack of understanding exactly the goal we’ve set. This leads to our judgment whether our actions are irrational or otherwise.

What the #e** are you doing? It might affect me!

A Game Theoretical Explanation

In a country, rather I should say in an environment, where a person is issued a death certificate when he requests for a wound certificate from a government hospital, and where a politician tries to indict others when he's caught into some fraud with strong evidences, and where we have to carry out a campaign or something like candle march protest for almost every other thing that should ideally be our rights such as getting metro rail project completed in time, saving girl child, having a effective Lokpaal, among others, it becomes very important how our neighbors behave. Neighbors do not necessarily mean that he or she should be staying or working just beside ours, rather every human being of this universe is our neighbor in some sense or other in this really localized world (by the way, why am I talking about only human beings? Isn’t animals and also the aliens our neighbor? Wikipedia describes neighbor as “A person living near or next door to the speaker or person referred to.”  Another standard dictionary defines the term as “A person who lives near another; one whose abode is not far off.” In those contexts, all human beings, Ah! Why again only human beings? Let me correct it! All human beings, animals, planets, and even aliens are our neighbors, because their abode is not very far off from ours, isn’t it? If not literally, then at least virtually they are stationed very much close to us. So, it is natural that one’s action will affect the others’ and vice versa. Do you agree? Nope? No worries! Let me tell you this simple phenomenon with the help of a simple example.

The Prisoner’s Dilemma, originally developed by Rand Corporation’s scientist Merrill Flood and Melvin Dresher in 1950, and subsequently articulated by Albert Tucker in its current form, is a fundamental problem in the Game Theory. It demonstrates why two people might not cooperate even if it is in both their best interests to do so. Now, game theory, an interesting concept widely used in social sciences, formal sciences, as well as life sciences, tells that an individual's success in making choices depends on the choices of others. So, Prisoner’s Dilemma tells us that even if we behave or attempt to behave in a supremely selfish manner, our actions are not always in our interest.

The Prisoner’s Dilemma can be explained in a hypothetical situation where I and you are conspirators in a crime, and we both are being interrogated in two separate cells and are not permitted to communicate with each other. Like all human beings, we are too highly selfish and assume ourselves as coldly rational. The officer who is interrogating us tells us separately that he has got sufficient evidence against each of us to put us in prison for two years. He further tells us that if you turn informer against me and help the officer to prosecute me, he will let you off right away but I would be given a sentence of five years straight. Then he makes the same offer to me also and we both are well aware that the identical offer is made to each of us. But the punch is that if both of us confess everything against other, we both will be away for four years each.

Well, so far so good! A typical Bollywood 70s-flick sequence, isn’t it? What should be the ideal course of action?

To quote this for Games Indian Play (written by Prof. V. Raghunathan of IIMA), the payoff sequence for each of us will be as follows, where the years behind the bars are indicated as negative numbers since it represents the undesirable consequence.

(1)   If you and I both cooperate and do not squeal on each other [U_C – I_C]:

·         We both will get away for two years each (–2, –2);

(2)   If you defect and squeal on me while I cooperate and do not squeal on you [U_D­ – I_C]:

·         You get off right away while I get prison for 5 years (0, –5);

(3)   If you cooperate and do not squeal on me, while I defect and squeal against you [U_C – I_D]:

·         You’re put behind for 5 years, but I get free right away (–5, 0);

(4)   If you and I both defect and squeal against each other [U_D – U_D]:

·         You and I both are put behind the bars for 4 years each (–4, –4).

So, these are the four possibilities. Being highly selfish and coldly rational, our responses to the offer will be what we believe as best for each of us; here friendship, decency, fairness and graciousness all are irrelevant. If we follow Game theory, ideally we should not squeal on each other (Option 1), in which case we both will get only two years of imprisonment (–2, –2) for each of us. But what exactly happens in such situation is like this: I believe that if you squeal on me and I don’t, you will get free and I will be put behind the bars for five years i.e. Option 2 (0, –5); you will feel the same i.e. Option 3 (–5, 0). So, hoping that you must be squealing on me, I also squeal on you, consequently, we both end up with the Option 4 (–4, –4)! Now, you tell me: is it purely rational and in our self-interest? NOPE! Not at all. But this is how we actually behave and act.

The above example is relevant to how our beliefs affect others’ positions as well as ours. We believe that we are acting rationally and doing what is in our best interest, but incidentally it turns out to be  bad for our neighbors (remember who’s our neighbors?), and worse for ourselves! Be it being silent on some serious issues, or anything else, it requires us to think more deeply before we take our steps out. Well, you might be wondering (by now, for sure) whether these issues have implications for our financial behaviors and other related actions of ours! Yes, of course! I would say. How? That I leave for you to think upon. Just conclude by saying that think of your neighbors (???) before each of your next moves next time.

We're Humane, We're (Calculatedly) Biased!

It is well accepted that Conservative Finance (I would prefer to call it so, rather calling it Traditional Finance!) theories derive their roots into the neo-classical economic theories, and the axioms of expected-utility (EU) theory, both assuming investors being rational and competent enough to take sound investment decisions. And if we further accept that intelligent (Huh!!), self-interested (Yeah! Perfect term!) individuals simply must be rational, then EU theory becomes a guide to positive or descriptive theories. Since the early 1950s academicians have been doing much of the theoretical work in economics and finance based on these joint assumptions. Lately, the assumptions which the mainstream financial theories are based on were challenged and behavioural economists contrast the EU paradigm to revise these models. 

Theorists in the new stream of "behavioural" finance do in fact allow for certain deviations from "rational" behaviour and thereby try to explain some of the empirical findings that seem contradict the standard finance theories. Supporters of behavioural finance have put aside the EU theory as a descriptive model and turned to the Prospect Theory or alternatives characterize human's decisions. Research by experimental economists, sociologists, and psychologists have made valuable contributions to the emerging field of behavioural finance. Let us now look at some of the driving factors [which have not been discussed so far in my blog, and] which are behind our (ir)rational behaviour in financial markets.

Image Source: http://www.riskpsychology.blogspot.com

(1) Allais' Paradox: Suppose you're faced with the following choices: In Case-1, Option A gives you Rs.100,000 for sure; and Option B gives Rs.500,000 with probability .10, Rs.100,000 with probability .89, and Rs.0 (Nil) with probability 0.01. You must choose either Option A or B. 

In Case-2, Option C gives Rs.100,000 with probability .11 and Rs.0 (Nil) with probability .89; Option D gives Rs.500,000 with probability .10 and Rs.0 (Nil) with probability .90. You must choose either of Option C and D.

It was noted that in Case-1, most people prefer Option A to Option B, evidently considering that the certainty of getting Rs.100,000 outweighs the chance of getting an extra Rs,400,000 at the risk of coming away empty handed. In Case-2, most people choose Option D, the Rs.500,000 gain over the Rs.100,000 gain offered by Option C and the probabilities looking about the same. It was pointed out that these model choices - A over B and D over C - violate the EU theory. 

This is how we, the humans, behave under certain conditions of risk!

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(2) The Certainty Effect: The certainty effect is documented by Kahneman and Tversky (1970) as the certainty of winning having some special significance to people. To show the impact of this bias on investor choice bias, let's take an example involving sums of money (because, we people deal with it in every day life). 

A series of cash prizes of, say X = {Rs.4000, Rs.3000, Rs.0}with two sets of probabilities, A = (.80, 0, .20) and B = (0, 1, 0). In this case, B is preferred to A. And if there is another sets of probabilities, say, C = (.20, 0, .80) and D = (0, .25, .75). Then C is preferred to D.

This choice preference for B over A is consistent with risk aversion (approving the phenomenon that one prefers the certainty of Rs.3000 to a gamble of higher expected payoff (i.e. Rs.3200). This example suggests that when people are faced with choices between a certain outcome (in first case, Rs.3000) and a risky one (Rs.3200), they prefer to go with the choice with certainty. But, when they are given to choose between two risky choices, they tend to prefer the one with higher gains (even if such choice involves lower probability). Here in second case, C (with expected outcome Rs.800; Rs.4000*.20+Rs.3000*0+Rs.0*.80) is preferred to D (with expected outcome Rs.750; Rs.4000*0+Rs.3000*.25+Rs.0*.75). It is interesting to note that the choice D has higher probability of positive outcome/gains (i.e. .25) than that of the choice C (i.e. .20). Again the EU theorem is violated! The Certainty Effect plays its role, doesn't it?

There are many other heuristics and other psychological biases at play in affecting choice behaviour of financial market participants. It's in the individual interest of ours that we identify those biases creating havoc in our investment decision making and avoid them as much as possible. What's up with you?

Your Money and Your Emotions: Keep it under check

"The Intelligent Investor" by Benjamin Graham is a wonderful book on value investing I came across in the course of the literature survey for my doctoral research. In this text, Ben Graham cites several examples using a metaphor Mr. Market. He is an obliging fellow who turns up everyday at the share holder's door offering to buy or sell his shares at a difference price. Often, the price quoted by Mr. Market seems plausible, but sometimes it is ridiculous. The investor is free to either agree with his quoted price and trade with him, or ignore him completely. Mr. market doesn't mind this, and will be back the following day to quote another price.

The point to mention this anecdote is to emphasize the observation that there is a large number of rules seemingly available in the market, offered by many like Mr Market. If you follow their rules, you are definitely loose, since you will end up as much a slave to Mr. Market as the professionals are.

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A wise piece of advise here is, instead, to recognize the controllable and control them i.e. try to follow your own rules. This is what Ben refers to as intelligent investing. You can't control whether the stocks or funds you buy will outperform the market today, next week, this month, or this year; in the short run, your returns will always be hostage to Mr. Market and his whims. But, you as investors (and particularly as investing human beings) can control the follwoing:

• your brokerage costs, by trading rarely, patiently, and cheaply; excessive trading involves huge costs in terms of brokerage, commisiion, etc.
• your ownership costs, by refusing to buy mutual funds with excessive annual expenses; exchange traded funds (ETFs) are relatively very much cheaper compared to open ended equity funds - go for them;
• your expectations, by using realism, not fantasy, to forecast your returns; don't consider yourself superior to others in terms of investing skills, knowledge, and abilities that you thing can outperform others;
• your risk, by deciding how much of your total assets to put at hazard in the stock market (following an intelligent asset allocation strategy), by diversifying, and by re-balancing your portfolio(s); and
• most of all, your own BEHAVIOUR.

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Investors in general nowadays watch, listen to and live with financial TV and magazines such as CNN IBN, NDTV Profit, ET Now, CNBC etc., and also read number of market columnists, they would often think that investing is some kind of sport, or a war, or a struggle for survival in a hostile wilderness. But investing isn't about beating others at their game; rather it's about controlling yourself at your own game. The challenge for the investor to become intelligent in the real stock market settings is not to find the stocks that will go up the most and down the least, but rather to prevent yourself from being your worst enemy - from buying high just because Mr. Market suggests you to "Buy!" and from selling low just because Mr. Market says "Sell!" So, keep your money and behaviour under check all the times you're into investing decision process.

Happy Investing!

PS: If this article interests you to know (li'l) more about keeping your expectations realistic while investing, you may also like to go through a great article "Keep it real: Are you basing your financial future on realistic expectations?" by Walter Updegrave, appeared in Money, February 2002. Click here to read the article.

Gold or Gold ETFs? Does Behavioural Phenomenon Hold Here?

For past couple of weeks, financial markets across the world have seen so many ups and downs caused by a series of events here and there. Some of these events such as Middle East crisis, Japanese Tsunami and subsequent nuclear issues, S&P's degradation of the US government's debt had shown and are still showing significant impact across the global financial markets. Volatility and uncertainty in financial markets is such that S&P CNX Nifty rose about 10% in the past one year, and BSE Sensex rose about 11.51% in the same period. Compared to this Gold has gained 26% in the same period.

Gold has emerged as a better investment alternative compared to stocks/equities. Global political and economic issues have just added some more flavor to this preference. Issues like recent political problems in Israel and North Africa, inflation issues in emerging economies and shallowing interest rates in developed countries have made gold an attractive and safer investment option, and institutional as well as individual investors are equally preferring to put some substantial portion of their portfolio in gold, either in form of physical gold coins and bars, or in gold exchange traded funds (ETFs). Here it would be interesting to note that price of gold have been shooting up in the recent past. Well, first, we should know what a gold ETF is (at least for our friends who have little idea about it). Gold ETFs are exchange traded products that invest in physical gold and continuously track the price of gold. Such exchange traded products include exchange traded funds (ETFs), exchange traded notes (ETNs), and gold closed ended funds (G-CEFs). For investors investing in such exchange traded products, it is very much similar to buying any other security (e.g. shares, bonds etc.), because in this case also they do not need to take or give physical delivery of gold. Investors thus can make investment according to their preferences just as they do with any other security.

Image courtesy: World Gold Council (http://www.gold.org)

So far so good, now you may ask why I've chosen the title of current post as the validity of behavioural phenomenon in gold vs. gold ETFs decisions? Ummm... it is quite possible that you might not gulp down the justification so easily, but, this is exactly what I wanted you to!! To make yourself think about the issue raised in the post!

Globally, there is a debate on whether investing in gold ETFs is different from buying physical gold. Let's put some points here. Like any other exchange traded funds, gold ETF is also simply an exchange traded fund that tracks the price of physical gold. The gold ETF moves in line with the price of gold. For example, if the price of gold goes up, so does the gold ETF, and vice versa. Another issue associated with gold ETF (rather, I must say, with any ETF) is the costs. Technically speaking, the Management Expense Ratio (MER) that covers the costs of managing any fund. Here, gold ETFs have got edge: the cost of gold ETFs is typically about 0.25% compared to that of other ETFs (~0.5% - 1.25%).

Now, we should see the concerns of holding physical gold. Unlike investing gold ETF (where you do not get physical gold), if you invest in physical gold, you get possession of physical gold in form of gold coins or bars. And positive aspects of investing in physical gold are its high liquidity and little credit risk involved; sense of proud belongingness comes attached! Though there is no immediate cash flows like in case of rental income from real estate or dividend from shares, there is likelihood that value of investment in gold  will go up in future.

Now comes the behavioural concerns in the choice between physical gold vs. gold ETF! We in India view gold in an altogether different perspective. In India, affinity for gold is associated with our cultural and religious values. It is considered as a store of wealth in a liquid, easy to access and tradable form, as well as sign of prosperity. A research report of Barclays Capital says that unlike investors in developed countries who are comfortable with holding intangible form of gold in form of gold ETFs, Indian investors are sort of apprehensive about investing in gold ETF, as it does not fulfill the desire of Indians wanting to hold a tangible asset that is no-one else's liability. They said that although Indian market is changing with new innovative investment products, more refining capacity and gold reserves replenished, the cultural affinity for the metal is secure. without a mass embracing of financial products, gold's hold is not going to replaced quickly within the next ten years. It is beleived that the jewelry cushion in India continues to exist and is set to soften gold's move lower when investment demand wanes.

Image source: http://www.trak.in

India has probably the largest fascination with gold than any other country in the world and is by far the world’s largest buyer of gold, accounting for 9.5 percent of the world’s total gold holdings.  More impressive is the fact that current demand from India alone consumes 25% of the world’s annual gold output. Gold is viewed in India as a symbol of power and wealth.  However more so nowadays, the people of India buy gold as a hedge of protection from their own rupee currency and government mismanagement.  Gold is highly valued so much so that it’s not uncommon for an Indian to use their gold jewelry as collateral for a loan.

The market for gold-based ETFs is in its growing stage in India. The asset under management (AUM) for gold ETFs has jumped nearly three-fold to Rs. 4,400 crore (figure as on 31st March, 2011) from  Rs. 1,590 crore (on March 31, 2011), which shows that appetite for buying virtual gold is slowly gaining popularity among domestic investor. There are as many as 11 asset management companies (AMCs) in India offering gold ETFs, including gold ETFs offered by SBI, HDFC, ICICI, UTI, Kotak, Reliance, Quantum, and so on.

Retail investors should take advantage of the growing opportunity of investing in gold ETFs, given the nature of diversity ( from typical securities) gold ETFs offered, the past trends in returns from gold ETFs, and other associated features. Happy Investing!!

Some Behavioral Issues in Indian IPOs

It is believed that about one hundred IPOs (Initial public offerings) with an expected size of around Rs. 50,000 crore are expected to land in the Indian stock market during the year 2011. The head of the investment banking arm of one of the multinational banks is quoted as saying that the year 2011 will see a massive bunch of issues hit the market unlike before and the issuers will have to price their trade more sensibly to attract investor attention [sic.]. Whenever it comes to participate in IPOs, investors see their adrenaline rush as they are believed to be searching for a "good" bet. It has been observed that investors are choosing companies to bid for in IPOs and are avoiding highly-priced IPOs. But it is also seen that they are bidding overwhelmingly in attractively-priced issues in the past such as CIL (Coal India Limited) and MOIL (MOIL Limited, formerly Manganese Ore India Limited). Experts say that it is a practice that shares of government enterprises are priced lower than their counterparts in private sector, while the price of shares of companies in private sector is usually determined above that of their peers. Though this practice has led come poor response and losses for investors, but no choice!

Renowned economist Hersh Shefrin who has done pioneering works in the area of behavioral finance identified three behavioral phenomena associated with initial public offerings (IPOs) as initial underpricing, long-term underperformance, and  "hot issue" market. In any IPO, there are three main parties involved in the offering: the issuing firm, the underwriter, and investors. Although the role of all stakeholders is important, the issue of concern here is the role of investors who are the most prone to any (and in fact, many) behavioral biases.

Image courtesy: India-commodity.com

The three behavioral phenomena namely, initial underpricing, long-term underperformance, and "hot issue" market, are against the principles of the efficient market hypothesis (EMH) which asserts that stock markets are 'informationally efficient', and has been in the central proposition of finance since early 70s. These phenomena mostly occurs in tandem. Issuers keep their offer price too low in order to attract large pool of investors. Thus the issue will be underpriced and initial underpricing occurs. Companies try to offer the initial issue at a very attractive price, as we can see in past cases including SKS Microfinance, Punjab & Sindh Bank, CIL, and MOIL. It is expected that private companies such as Jindal Power and Sterlite Energy which are planning to come up with their IPOs during the year 2011 can have a lower valuations as investors might turn choosy, having profited from attractively-priced state-owned companies' issues in the recent past.

When the issue is underpriced and it is deemed to be an attractive offer, it leads to an excessive first-day trading, subsequently its price will soar on the first trading day. But as the EMH rules the market to some extent, the market will get to know the company's fundamentals. In case the price overshoots fundamental value, the price will fall back over time as soon as the market assesses the fundamentals right. This phenomenon was seen in case of the offers of Claris Lifesciences and AtoZ Engineering, when investors shunned the initial price shoots up shortly after the first-trading day. The decline in share prices under this situations will give rise to long-term underperformance of that share.

Image courtsey: nsdl.co.in

With such sharp fluctuations in share prices immediately after the initial public offering, IPO activity also tend to move in hot and cold cycles. When the investors' demand for any IPOs is very high, that state of market can be called as a hot issue market. A very interesting example of such nature is the initial public offering of Reliance Power in the beginning of the year 2008. When the issue for Reliance Power shares with a price band  of Rs. 405- Rs. 450, closes on 18th January 2008, investors had bid for as many as 72 times the number of shares that the company offered on the block under its IPO. Investors had put in bids for over 1,654.8 crores shares as against the 22.8 crore shares on offer. The demand for the shares was such that almost every single person in the street (with the capability of invest the minimum required money into those shares) was rushing to get a demat accout so that he would not miss the opportunity. Sources in media reported that  National Securities Depository Ltd. (NSDL) has shown that the number of active account grew from 5.22 lakh during July-September 2007 to 7.25 lakh during October-December 2007. Something similar happened at another depository CDSL where the number grew even more dramatically from 3.8 lakh in third quarter to 6.9 lakh in the fourth quarter of 2007. An official of one of the major stock broking houses said, "Since the Reliance IPO was announced, there is a line outside every DP office and hundreds of application forms are pending and it seems like a mad rush of people wanting to open demat accounts." Somewhat similar phenomena was seen when the IPO of CIL was on offer. These times are referred to as a hot issue market when investors' IPO-adrenaline rush to track a best bet.

The issuers while going public always hope to obtain the best price for their shares that they can. Therefore, it will be in their interest if they time their issue (of IPO) for when sentiment is positive and investors are particularly optimistic. The evidences for hot markets (as earlier discussed also) is actually strong. Though research has shown that both investors and managers are unduly optimistic about the future prospects of the issuing firm (Loughran & Ritter, 2004). A word of caution for investors: take a note of these behavioral phenomena associated with IPOs! During the year 2011, a large number of initial public offerings are expected to come, and also they are supposed to be attractively priced, for sure. IPOs such as Delhi Metro Rail Corporation (DMRC), Reliance Life, Super Religare Laboratories (SRL), and HDFC Life are of especial interest for investors. Let's wait and watch if these phenomena persist in the market and if yes, to what extent.