Feb 17, 2010|
Beware of the bargain
Experts believe that investing is more of an art than a perfect science. It is not governed by flawless laws and theories. Like other arts it is driven more or less by emotions. Mr. Market is a sentimental being. His mood swings from excessive optimism to deep pessimism. Isn't it?
Similarly we all are emotional beings driven by feelings. But again, undisciplined emotions can do a lot of harm in investing. They tend to cloud our intelligence, making our decision-making biased. We have previously discussed about confirmation bias. We tend to over emphasize the news that confirms our original opinion about a thing, person or investment.
Another such very common human emotion is denial to accept one's mistake. No one wants to be proved wrong and tends to stick to ones decision even after subconsciously knowing that it was wrong. In investing this often leads to an 'escalation bias'.
What is escalation bias?
This is the tendency of investors to commit more money to the loss-making investments as an attempt to average down the purchase price. Here investors are often confronted with a dilemma. Whether the rapidly falling price indicates a more lucrative opportunity to gather more or it signifies flaw in the original investment rationale, is a very tough decision to make.
Let us explain this in simpler terms. Suppose you purchased a stock 'ABC' for Rs 100 some time back. Now the stock is trading at Rs 70. You will be tempted to buy more of it. After all it is screaming a bargain at that price. You might as well buy some more of them and bring your average purchase price lower. We cannot blame you. It makes sense. However, it becomes a problem when you tend to ignore the bad news coming about the stock which is pushing its price lower. It is the denial to accept the mistake that leads one to undervalue information which is against the original decision. Meanwhile, one tends to escalate the size of investment by putting in more time and money into it.
We can cite few more examples of escalation bias in the corporate world
- Corporate leaders many a times favour reinvestments in less successful projects and non value adding assets rather than those which are doing well. This is called as "sunk cost fallacy".
- In season sales, offers like "Buy 2, get one free", often lure shoppers in buying more of mediocre items, just because they are selling at a 33% discount.
How to avoid escalation bias while picking stocks?
It is definitely a tough call. But can we avoid this bias? We believe, yes! When confronted with such a bargain offer, an intelligent investor should re-evaluate his position in light of any recent negative news about the stock the company. One might have missed to factor in some regulatory change or bad investment plan while originally investing in the stock. If the judicious evaluation still points to a buy, don't wait! Buy more of it. Otherwise, it is still not late to accept the mistake and exit the investment. To conclude, we believe it is wise to be disciplined and not throw one's good money for bad.
Afterall, "In the end, how your investments behave is much less important than how you behave." - Benjamin Graham (The intelligent investor)
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