Thoughts

"Chasing after the impossible, you lose what is possible."

House money effect and discount coupons

B. Venkatesh

My wife and I converted the reward points on our credit cards to discount coupons redeemable at a certain store. We laboriously exhausted our coupons over three months. We would have certainly avoided some of the purchases at that store had it not been for the coupons. Why was our behaviour altered when we used discount coupons?

The answer lies in what behavioural economists call the house money effect. Suppose you walked into this store and found a top or a shirt for Rs 2,000. On a typical day, you would have been appalled at the rate. But on this day, you are not, shopping as you are with discount coupons. You, therefore, buy the top or the shirt. Why?

No pain of paying

You do not suffer the pain of paying for the purchase. You reason that the credit card company is paying you to spend at this store. This behaviour is called house money effect.

It is named after the behaviour gamblers exhibit after they win at the table. They typically feel that they have house (casino) money after a win and, therefore, take larger bets on the next round. It is the same behaviour that prompts an equity trader to take large bets after she profits on a trade.

Our purchase decision at the store carried a deadweight loss. That is, the utility value we derived from the products that we bought was far less than the price we paid for it with our discount coupons.

Irrational decision?

Were we irrational in our purchasing decision? Had we used our credit card just to earn the reward points, then our purchase decision at the store would have been irrational. Why?

The discount coupons would then carry a price — the wasteful shopping that we did to earn the reward points. But we did not. Even if all credit card companies stop offering reward points, we would (I presume) still spend the same amount with the plastic. The coupons were, hence, free money. We were in the wrong store.

(The author is a self-styled investment psychologist. He can be reached at enhancek@gmail.com)

Sourced from: http://www.thehindubusinessline.com/

Book-building at work

Aarati Krishnan

Putting your money into a company’s IPO (Initial Public Offering) is now as easy as pie. Three clicks online and you’re done, without needing to fill out all those annoying little boxes in the application form. But what is NOT easy is wading through the tide of jargon that hits you in IPO season. Let’s decipher a few terms now whizzing around and put them in plain-speak.

Cut-off

First, the cut-off price. No, it’s nothing to do with buying a pair of jeans and hacking at it with blunt scissors to get a cooler-looking pair! Cut-off price is the price at which an IPO is finally priced. Or simply, the price at which you will finally be allotted shares in the company making the offer. Now, why call it cut-off? Because this is the price at which bids for the offer are literally cut off. Investors bidding below the cut-off price in a book-built offer will not get the shares they covet.

That brings us to how a book-built offer works. A book-built offer allows investors to put in bids at different prices for the shares of the company making the offer.

Much like in an auction, the company opens its “book” on a specific date (book-making is a term derived from horse racing) to invites bids for its shares.

Investors have a five-day window to decide on and bid for, the shares being offered. Just so we avoid the temptation to put in a ridiculously low sum, the company selling shares has the right to set a price band — the upper and lower limits — within which it will accept bids. Once the offer closes, the company will decide on the cut-off price or the winning price. If you tried to drive a hard bargain and bid below the cut-off price, your application will be rejected and you will receive a refund of all your money. If you put in a bid above the cut-off price, you will be allotted shares at the cut-off price.

Who wins?

How is this cut-off price decided? Does the highest bidder win? Or is it price chosen by the majority of investors?

Neither. The book-building process in India follows the Dutch auction method. In this kind of auction, the highest price at which the issuer gets bids for all the shares on offer, is the cut-off price.

Suppose Eat-away Fast Foods is offering 10,000 shares through a book-built IPO in the price band Rs 20-25. The IPO opens and at the end of five days, they find that: 5,000 bids are received at Rs 25, 2,500 bids at Rs 24 and another 2,500 bids at Rs 23. Rs 23 is the winning price, that can be set as the cut-off price. That is the highest price at which the issuer was able to get bids for all his shares. Once the price is “discovered” in this manner, the issuer can decide to set the cut-off price below this. But he cannot allot shares at any price higher than this level.

But wait, what if I have no clue how to value a company? How will I know what to bid? Well, that’s why retail investors alone have been given the extra option of bidding “at cut-off price” in every book-built IPO. When you choose the “Bid at cut-off” option on the application, you are basically telling the issuer: “I like this company but don’t know its price. So I’ll just sit back and let the other institutional guys fight over the price.”

Bidding at cut-off ensures that no matter what price is discovered for the IPO, you will be allotted shares at that price.

Sourced from: http://www.thehindubusinessline.com/

Thoughts

"Failure means delay not defeat."

All-inclusive pricing

B. Venkatesh

The cab drivers at the Bangalore airport charge an all-inclusive rate per kilometre for ferrying you to the city. That is, you are not charged additionally for using the air-conditioner (AC) in the car. This pricing system has affected their behaviour, for most of them seem reluctant to switch on the AC. Why?

Consider the normal practice, called partition pricing. You pay a variable rate per kilometre (km). If you use the AC, the variable rate is higher. Your conscious decision to pay a higher fare forces the cab driver to switch on the AC.

In an all-inclusive fare, the cab driver gets the variable rate, whether a customer uses the AC or not. The driver, hence, chooses not to switch on the AC, as that saves costs and increases his profits.

But is an all-inclusive pricing optimal? Studies in behavioural economics show that such pricing makes economic sense when the seller wants the customer to focus on the core offering.

Framing bias

Suppose you are shopping for a home AC. The seller can offer an all-inclusive price, which includes the stabiliser and the AC. Or he can offer a partition price, where each product is priced separately.

If the stabiliser is just a normal brand, the seller might as well offer an all-inclusive price. Why? Pricing the stabiliser separately catches our attention. We may choose not to buy it if we believe we can get better quality elsewhere.

If the seller instead makes an all-inclusive offer, we may focus our attention on the AC and just take the stabiliser that is given to us.

The difference in our behaviour, perhaps, has to do with the framing bias. Paying separately for the stabiliser means we need to take another decision besides buying the AC.

Our need to justify the pain of making another payment causes us to analyse the product. And reject it often. Taking a decision for an all-inclusive product is less difficult. Is that why the cab drivers adopt an all-inclusive price?

(The author is an investment psychologist. He can be reached at enhancek@gmail.com)

Sourced from : http://www.thehindubusinessline.com/

Thoughts

"Stop existing. Start living."

Flower power

Adarsh Gopalakrishnan

Writers who profile financial manias can seldom resist the temptation to start with the Tulip mania of the 1600s. Tulip mania is a tale of how free markets, when not reined in, can wreak havoc on wealth and even society. Popular accounts of ‘Tulip mania’ portray an entire nation crazed and bidding for flowers and ultimately driving their prices sky high.

The ensuing crash in their prices was said to have bankrupted a nation. Most references to the Tulip mania cite Charles Mackay’s more popular account which uses this to describe how unfettered markets can lead to wild pricing. However, a more detailed and sober account by Anne Goldgar holds some subtle, yet valuable, lessons for investors.

Tulip exchanges

Here’s the tale of the Tulip mania. In the early 1600s, the price of several varieties of tulip bulbs were bid up several-fold on the back of heavy demand. In fact, certain varieties of tulips multiplied 12-fold between December 1636 and February 1637. There is even the case of a variety of tulip — Groot Gepluymaseerde — which saw its prices double in just two weeks!

Goldgar’s account suggests that Mackay’s account may be somewhat exaggerated. Firstly, the tulip was not a flower which appeared out of the blue and swept the Dutch off their feet.

Several varieties of the tulip bulb had appeared over 50 years, leading up to the crisis. They were used as gifts and on early occasions traded by individuals.

What actually brought the mania to a head was a newly affluent Dutch society, in the midst of the ‘Dutch golden age’. With trading fuelling the Dutch to the forefront of the global economy in the 1600s, the Tulip mania was a largely urban phenomenon with huge transactions happening in Amsterdam and Harleem.

Discussion and bidding for tulips happened in inns and taverns, which doubled up as informal “tulip exchanges”. The keepers of these inns often served as witnesses for the tulip transactions. The participants in a majority of these transactions were textile traders, brewers, artists and craftsmen.

Tulips remained in the ground for a large part of the year only to be dug out in May or June and, for longevity, replaced in the ground . Transactions would take place over the winter, with the buyer and seller agreeing on a price during winter for a bulb that would be harvested three-four months later.

The early beginnings of a “futures” market? The price of each Tulip was set based on the size, shape, colour and pattern of the expected flower. All four ‘features’ were subject to guesses, as very little knowledge on genetics or physiology existed then.

Soon, trading for tulips became a highly profitable venture and partnerships began to emerge. As the famous comparisions go, 1,000 florins ($12,000) could buy you 12,500 kilos of bread or a single Tulip.

Another comparison involved how two measures of wheat, four of rye, four fat oxen, eight fat pigs, twelve ox heads of wine, 3800 litres of beer, and so on, plus a ship to carry them in could buy a single viceroy tulip bulb! Why did prices climb so high? Well, one theory even has it that euphoria from having survived the plague aided the frenzy for Tulips!

How, then, did the crash happen? There are several theories, including one that a bidding war of less-than-expected enthusiasm led to a dominoes effect on Tulip prices. Finally, when the crash came along, several obese check books turned pleasantly plump. Business did slow down, bankruptcies (often wrongly attributed to the tulip mania) did happen. But tulip trading did not end….

What’s in it for investors

While it may appear silly for investors to have paid a fortune in December for flowers they could only see next summer, do note that many modern futures contracts are similar. When we bet on the September futures of Reliance, we are betting that the underlying assets will be worth more! This is not unlike paying for Tulips in December which one can see only in March.

The sane explanation could be that whether it is Tulips or shares, the price one is willing to pay for them is as much a product of psychology as it is of valuation. As Goldgar puts it, “value is a cultural construct”.

The concept of ‘good faith’, that is buyer and seller sticking to their end of the bargain, plays an important role in market confidence. When ‘good faith’ is tested by an event- like the crash in Tulip markets- the market fabric begins to unravel.

For the more cynical investor, Charles Mackay had a useful line ‘Men, it has been said, think in herds; it will be seen go mad in herds, while they only recover their senses slowly and one by one.’

Sourced from : http://www.thehindubusinessline.com/

The long and short of it

Bhavana Acharya

“Don’t worry about market fluctuations. Think long term.” Now that’s something that investors, young and old alike, would have been told repeatedly while their equity investments yo-yoed with the ups and down in the stock market in the last two years.

But what exactly is long term? Is it a year or two or is it, like, forever? And should you really just take a nap while the market is battering your portfolio with its wild swings? Here’s more on the subject.

Defining tenures

Though investment gurus often ask us to hold for the “long term”, did you know that “long term” actually means different things to different people? Investment advisors such as Warren Buffet, who buy stocks on the strength of the underlying business, have been known to stick to their choices as the business grows and matures; for them, long term is a holding period of ten to fifteen years!

But investors in the Indian context tend to be a bit more impatient and even fund managers typically ask investors to take a “three-five year view”.

The definition of long term or short term can also differ based on who is talking about the investment. When a fundamental analyst recommends a stock on the basis of a company’s business, he would generally advise a holding period of at least three years. On the other hand, a technical analyst may peg short-term calls to between ten and twelve trading sessions, while their long-term calls take up to a year to deliver.

Taxmen too have a different definition of long term. Here, short-term investments indicate a holding period of less than a year. Any security held for a year or more becomes a long-term investment.

Why define tenure

The risk involved in investing for the short or long term varies much as how a stock behaves in a day or a week can radically differ from how it performs over a number of years.

While there are some stocks on which you can build gains only if you hold them for a few years and watch the business grow — such stocks move gradually and will provide rather meagre returns even over a few months — there are others you can only rely on for quick gains.
Most seasoned market players will be able to reel out a string of stocks that head for the stratosphere in every bull phase; but sink into oblivion when the markets aren’t scaling new highs every day.

Defining your investment period, therefore, assumes significance because the stocks you choose will have to fit into one of the above slots. The risk and returns involved too depend on how long you are willing to hold that stock.

As a rule, short-term investments hold greater risks, but may deliver higher returns (or losses), whereas for long-dated investments, there is enough time for the stock price to capture the growth of the underlying business.

If you’ve done a good job of identifying a growing business, the stock price will eventually catch up.

How to select

Well, so much for the risk. But how do you go about selecting stocks? Remember short and long-term investments are to be made with different returns perspectives in mind. The key in a long-term call lies first in the industry selection because some industries, such as sugar and pharma, are cyclical and may not deliver.

So, you’ve first got to study the prospects of the sector, and how it may develop over the next few years. In addition, study the fortunes of related key industries. Later on, a fundamental analysis of the company will give you the prospects of that company within the industry. On the other hand, short-term stock picks — primarily trading picks — must be based on analyses of charts and price patterns, immediate market outlook, tips and news flows.

Is there a ‘best option’?

Lesson one: Simply buying and holding stocks does not necessarily guarantee substantial returns, or even returns at all. Here’s why.

Had you bought the stock of textile company Arvind Mills back in July 2004, you would be sitting on a loss of 66 per cent per share today. Or if we take the Sensex itself, the five-year absolute returns (from July 2004 to July 2009) is a neat 200 per cent. But had you exited in December 2007, your returns would have been higher at 302 per cent.

Lesson two: However, holding a stock merely for a long period isn’t enough. Constant monitoring of investments is a must.

Consider the case of Gillette India. In the period between January 2000 and July 2009, the stock has lost 63 per cent of its price. Similarly, the stock of Sonata Software erased away 95 per cent of price in the last nine years.

Lesson three: Avoid the temptation to convert your bad short-term investments into your long term “portfolio”. That’s a good way to ensure that your portfolio is made up of stocks that you wouldn’t particularly like to own.

Suppose you bought the stock of Entertainment Network from a short-term perspective at, say, Rs 261 in end September ’08. In hindsight we know that the stock took a downward turn and hasn’t touched your expected sell price since. What should you do then? Investments marked for the short-term are best for the short-term only.

Converting them into a long term one may not be the wisest choice, even if you were sitting on losses on the stock. Continuing with Entertainment Network, had you held on to the stock, you would still be at a 26 per cent loss, which could have been less than 10 per cent had if you exited the stock in the beginning of October.

Standing by decisions

So, the point to note is that whatever your investment decision is, the key is discipline. Stick to your investment period, and your targeted return.

A short-term call isn’t likely to behave in the manner you wish in the long term. Losses you may be sitting on now may worsen in the long term if the industry or the company itself is on a downswing or if its business or operating capabilities are questionable.

In a long-term investment, don’t simply put your money in and then entirely ignore it and look at it after a good many years.

Keep a watch on the price from time to time, and if you are of the opinion that the price has run up from when you got it, or your stock has hit your expected sell price, cash in your profits while keeping your capital in. That way, you make a profit, but will still be able to benefit from a further price rise.

Sourced from : http://www.thehindubusinessline.com/

Thoughts

"A candle loses nothing by lighting another candle."