Abstract Choices and Portfolio Selection

You are rated as a "Good Performer" in your company annual performance review

Decision Point 1
- Would you buy an insurance policy that provides for 12 months salary if you are laid-off ?

Most of us would say "No". After all you are rated a Good performer and it is highly unlikely that if such a thing happens you would not be the one at the receiving end of things.

Most of us think that they would be relatively better off in an uncertainty and fail to consider the rational alternatives in the event of an uncertain event and base our choices on predefined "heuristics" that are based on our emotional predisposition rather than an objective selection amongst alternatives.

As our decisions are based on emotional predisposition we end up making choices that are objectively incorrect. Just because an objectively incorrect decision turned out to be the right one does not make it the best decision.

Now to rephrase the above decision point if i ask the question..

Decision Point 2
-- "Would you buy an insurance policy that provides for 12 months salary if you are laid-off because the company did misreably due to the current economic recession OR because it got acquired"

Most of us would say "I'll think over it"..

Now the conditional probability of you getting laid off (which includes layoff due to recession or acquisition) is greater than you getting laid off because the company had a bad year.

However in the first choice you (most likely) evaluate the decision based on your assumption that the most likely reason for someone to get laid off are because they are a poor performer and hence on your confidence on your ability is the driving emotion behind the decison

In the second choice you are now anchoring your choice on the likelihood of the company doing bad.. emotionally our confidence in our abilities is greater than our confidence in others abilities.
So as there are "many idiots in top management"(a universal belief shared by even the employees of most successful companies) your confidence in the company's ability to do well is less than your confidence in your ability.

Now we further rephrase the above question..
Decision Point 1.1 (Assuming you said "No" to decision point 1)
- Would you buy an insurance policy that has annual premium 0.1% of your salary and that provides for 12 months salary if you are laid-off ?

In 30 years this premium would amount to 3% of your annual salary and now saying "No" would mean that you are almost 100% sure that you will never get laid off in your working career.

Yet i would not be surprised if many of us actually decline this decision point and stick to "No"..

The reasons are again emotive..

Based on our previous decision that we would not want this insurance policy we are closing our mind at rationally evaluating the new piece of information (0.1% premium rate) and building that into our decision making process.

This happens often when we brand someone as a "star performer" based on our (often) first impressions of someone's capability or quality of work.. Similarly those who have initially not got into the "good books" in terms of how their performance is perceived are unlikely to subsequently get career growth opportunities.

After all Humans are wired to think emotionally..

I'll summarize the discussion into 2 points..
A] We prefer the concrete over the abstract even though rationally the abstract may be more valuable than the concrete (As seen by the choice on insurance policies)

B] Once we decide on a choice the future decisions depend a lot on past choice and we do not objectively incorporate new information into the decision making process..

Now how does this influence our portfolio selection..

- Averaging down a bad stock and then
- Holding on to a loser after you have realized your mistake

==> I had a colleague at Sun Microsystems who had bought the stock at $100 when the .com bubble was at it's peak and Sun was what probably Apple is today..

Eventually the stock started coming down 100-70-40-17 and at each fall more was bought because "it could not go down more than that" and the fundamental belief that the company was good..

He bought more at 9-5-3 dollars and his "averaged down" price was something like $10. Other rational employees who incorporated the "new" information of the dwindling fundamentals "sold" the stock when it
went up a bit and got out. But not this person.. His choice was dependent on his past choice and not on rational and objective evaluation of current data.

I wonder how many Satyam employees are trying to "average down"

Eventually my colleague realized that the fundamentals had deteriorated and the stock should be sold. However he had too much invested (almost half his savings were in the stock) and getting out would mean huge losses. This meant holding on to the losing position with a risk of losing out further.. (i.e an investment with a potential for a downside is always a bad investment irrespective of whether you are profitable or at a loss)

Eventually the company went down and was sold for around $2.

Now assuming that our Human investor had $1000 in investment (at average $10 this is 100 stocks) and when the stock was at $5 he realized that the fundamentals were pointing to a downside risk.

A rational investor would book losses and take the remaining $500 and invest in something with a upside potential. Assuming the new investment is good his portfolio would be worth maybe $700. Holding on to the losers meant that his portfolio is now $200 and it would take some luck to get it to $700

It is possible that at times holding on to a loser (that you now believe would lose further) you would get lucky and recoup your investment. would it mean that you took the "right" decision to hold on to the loser.
I would say that your decision was still wrong and you were lucky. i.e a Lucky Fool

The preference for the concrete also leads us to choose from a limited subset of "known companies" I know many friends at Infosys whose portfolio consists of Infosys, Wipro and TCS stock (and now PERSISTENT).
When asked why they dont buy something like Sterlite.. the comment i often get back is "What does this company do?"

Secondly we tend to value a stock on its absolute price and the price in relation to past price rather than do some valuation in terms of market capitalization. If a certain stock goes down from $15 to $11 we will think
that its a good time to buy it at $11 WITHOUT analyzing if it has gone down because it was fundamentally overvalued and the movement from 14 to 11 is a correction or if the fundamentals are intact and this move presents a buying opportunity. Similarly folks who sold something at $11 will repent if the stuff went from $11 to $15 WITHOUT analyzing if their selling decision was based on their fundamentals and if so then it was the right decision at the time. Similarly if they now believe that new information warrants that the fundamentals have improved and there is an upside even at $15 then they should actually BUY at $15 (irrespective if they have sold it at $11)

Lastly rational decisions may not turn out to be the right decisions in terms of favourability of the outcome. N N Taleb has an interesting anaology of the Russion Roulette (a revolver has 6 slots one of which has a bullet) The trigger is pulled, you either win a $1million dollars or become a part of history.

You and your friend are given the option. You opt out, fearing for your life. Your friend opts in and wins !!! Would you then say that "i wish it was me who got the million.." A favourable outcome based on irrational choice is still a bad decision.

Talking about the markets i see much more probability of a downside than a significant upside from the 18000 levels. Euro debt crisis is not over, China bubble is heating up, India growth story is strong but that has already been built into the price.. Rationality dictated that one should sell off and sit on the sidelines. There is a possibility that FIIs may pump more money and take the index to 20000 but that does not mean that the decision is wrong because it was based on objective rationality..