Classical Economics assumes that man is rational. But man is a rationalizing animal, not a rational animal. And hence what should work in theory does not work in practice.

Here are just two examples.

Example 1: Game of Ultimatum

Say, you and I play the Game of Ultimatum. There is pot of Rs 100. You propose a way for both of us to split this money. If I accept, then we go ahead and split it. If I reject, then neither of us receives anything. You are the proposer and I am the responder.

Let’s also assume that both of us are greedy, rational and unemotional. So what should you propose? You should make ridiculous offer of something like Rs 99 for yourself and Rs 1 for me. Why so? Because if I am rational, my thought process would be like: I accept the offer and I get Rs 1 and if I reject and I get Rs 0. So even though it may seem unfair, it is better for me to accept it.

But in reality, I am just going to be enraged at the unfairness. Why should you keep Rs 99 and I get only Rs 1? After all, I am the responder and the final outcome depends on me and why should I be cheated out of the outcome. So I am going to do something totally irrational and reject the offer. By rejecting the offer, I am going to lose Rs 1 but make sure you will lose Rs 99. While I am worse off by rejecting it, I make sure you are 99 times worse off than me!

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Example 2: Supply should increase when price increases

Classical economics says that when prices rises the supply should increase. I picked this from David McWilliams’ book: Money: A Story of Humanity. (McWilliams himself is an economist and a former UK Central Banker. And hence I am going use him as a Shanka to say whatever I want to.)

A second fundamental law contends that when prices rise, supply will rise. But is this always accurate? In a rising market, a would-be seller has second thoughts. She thinks, with prices rising, she’d be mad to sell now, when she could sell next year and make more money. She shares this observation with her friends. They all wait for a better price tomorrow rather than selling today. But rising prices do not always cause supply to rise; they can, in fact, cause supply to contract, squeezing the price skywards on a journey from boom to bust. Classical economics tells us that price is some mechanical instrument that signals sterile ‘equilibrium’ between supply and demand, where the economy is stable. Only blackboard economists think of prices like that.

McWilliams, David. Money: A Story of Humanity

This has happened to me and I am sure it has happened to you, too. Last year, during the bull run, one of the stocks I owned kept going up everyday. It was Rs 700 per share in March and Rs 1400 in mid-June. When it reached around Rs 2000 I sold some. The price didn’t stop there. It went higher and higher and instead of selling more, I froze.

A rational person would’ve thought, if it was good enough to sell at Rs 2000, it should be even better to sell at Rs 2200. But in reality, we freeze instead of selling, we hold onto it even more. That is as prices rise, supply reduces.

A friend and senior investor told me his story. He bought a company at Rs 25 per share and a few years later it was at Rs 600+ per share. And instead of selling and making a killing he held on because per his “information” and his “calculation” it was destined for Rs 900. I mean who wants to be guy who exited the party early? If you sold it at Rs 600 and the stock did go to Rs 900, you will forget the journey from Rs 25 to Rs 600 and keep feeling sad about missing the Rs 900 that could’ve been if only…. that stock today is available for a princely sum of Rs 300. (It never went to Rs 900!!)

Not just stocks. People that invest in land and see the property price go up feel the same even when the prices have gone up insanely. Why sell today, when you can sell tomorrow for more? Kishore Biyani refused to dilute equity because he thought- I’ll get a higher price tomorrow.

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So, you see, economics works beautifully in theory. But outcomes in reality are messy. And therefore you need to also study behavioral economics. Behavioral economics explains how humans actually make real life economic decisions.

Here is a small list of big biases.

1. Framing effect

We perceive value based on how things are positioned to us. A Mercedes is positioned to convey luxury, comfort and exclusivity but almost never stands about fuel efficiency. It is like saying I am so rich without actually saying it.

Now imagine if I told you there is a technology company, that earns 30%+ return on capital. But if you adjust for all the excess cash on its books, it’s return on capital would be like 70%+. In fact, it is one of those platform companies where you can scale the platform without any cost. Because it does not need any capital to grow, it pays a lot of profits to shareholders as dividend. What kind of a Price to Earnings multiple should this company command? 30 X? 40 X? 50 X?

Let’s contrast it with another company that is a government run company whose management’s communication skills are average at best. There isn’t much growth in the business this year and god knows if there’ll be any next year. Everything about the company is boring: it’s name is boring, it’s presentations are boring, it’s logo is boring and it’s management’s commentary is boring. And the name of the company indicates it is in some scrap buying and selling business. What kind of a Price to Earnings multiple would this company command? 10 X? 20 X?

The first company is thought of some sleek technology company doing some cool things. The second company is thought of as a boring, mismanaged company. So, you see depending on how the story is framed and sold to us, our perceived value changes. One is a tech platform the other is a boring railway platform. Do you agree?

(The first and the second company are one and the same.)

2. Anchoring

Anchors give us meaning, a benchmark to compare. For example, when we compare ourselves with where we were 10 years ago, we may feel happier. And when we compare ourselves to our neighbor, we feel sad. Or vice-versa.

Absolute has no meaning; relative does. (There was a Math exam in 11th standard. My friend got 95 out of 100 and yet he was sad. Because the exam was so easy that a majority of the kids got 100!)

Most of us are anchored to the price we paid for a stock. And our gains and losses are with respect to that anchor. Another anchor we use is the price at which the company first came to the market- the IPO price. People think they are buying something cheap if it is lower than the IPO price. Just because something is cheaper does not make it cheap. And just because something is 10 X more than what it was 5 years back, does not make it expensive.

The anchor should not be yesterday’s price, but instead the future anticipated price. A stock that has grown 10 X may have the wherewithal to grow another 5 X and hence may make sense to buy.

You set the wrong anchor and you perceive the wrong value.

3. Recency

What happened in the distant past is forgotten. What happened recently clouds our minds.

Right now, we can only think of Trump and tariffs. So much so that we forget some simple truths. Like why should tariffs impact a logistics company that operates only in India? But no- the spectre of tariffs, US recession etc. etc. is so huge that we’d rather go with the crowd.

When the market is hot, Mutual Fund companies fall over themselves in launching thematic based on the flavor of the season. When the market is down, the same companies switch to Multi-Asset funds. Why? Because that is what is on everybody’s mind. And what’s on your mind is what’s easy to sell to you. (Tip: A way to become popular on social media is to attach yourself to recent happenings. Because that is what is on everybody’s mind. )

4. Authority Bias

I had written a blog on this: Shanka dinda teertha on this same topic. Who says what and in what context etc. matters a lot.

My friends and I share investing ideas on a regular basis. I presented on a company in 2021. Then the company became a fundamentally better company in 2022 and was available at a much lower price. I presented it again in 2022. My friends didn’t think much of the idea. Then Prof. Sanjay Bakshi wrote about it in 2023. And suddenly, not just my friends, even the market woke up and took notice.

What I said was regular water. The same thing as told by Prof. was holy water. However, I am never the one to miss out on rubbing it into my friends when I am right :).

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What the market forgets is what the value investor seeks. What is a beautiful swan today can become an ugly duckling tomorrow. And vice-versa. What is a beautiful platform company today can become a boring PSU tomorrow. And vice-versa. What is a green energy financier today becomes a reckless lender tomorrow. And vice versa. It all depends on framing, contrasting, anchoring, recency, authority etc. etc. etc.

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My friend PJ and I have collected 600+ case studies on human biases. It’s not like I am smart and the world is stupid. Far from it. By collecting these case studies we are training ourselves to be a little more rational today than yesterday. And it’s humbling…because I can make the same mistakes that other people have. And quite a few of those 600 include our own follies.

-Cheers

PS: I recently watched an interview of Mr. Rajeev Thakker and he was passionately explaining Behavioral Economics. Why do I need an original idea for a blog when I could shamelessly clone.