Tuesday, June 8, 2010

An interesting (and profitable) experiment..

As I had mentioned in my introductory post, as a hobby, I teach in 3 B-Schools in Pune as a visiting faculty. Besides the regular syllabus, I discuss lots about psychology, investor behaviour etc in class. Sometimes, I also conduct certain experiments where my poor students become the guinea-pigs! (evil smile)
I recently conducted an experiment in Behavioural Finance which i had adapted from one of the many books i read on the subject. The results were pretty interesting!

I started by telling the students that I am going to sell them a Rs.50 note. The concept of 'buying money' itself was a bit hard to digest for some, but what the hell. I also told them that this note was signed by a very famous personality and they could get at least Rs.1000 if they sold that autograph. (This was a mere distraction; the note was signed by just me, but I refused to tell them whose sign it was!!) Almost everyone started fixating on whose signature it might be.
Then I asked them how much would they pay for it. Most of the students quoted an amount up to Rs.50. Some dare-devils also quoted beyond 50. I asked them if they would be ready to buy this Rs.50 note for Rs.5. Everyone said yes. So I said lets have an auction. The auction had the following rules;
  1. The bids would start at Rs.5 and in multiples of Rs.5 thereafter.
  2. A person can talk only to place the bid during the auction and for no other reason. (So that no-one influences others)
  3. The highest bidder wins the auction and gets the Rs.50 note.
  4. The second highest bidder (runner-up) has to pay me an amount equivalent to his bid. (This was the critical condition which no-one really understood. They were all busy thinking about the signature!)
Well, the auction started at Rs.5 and rapidly went up to Rs.45. Almost everyone was interested in bidding. I now told them that the signature was mine and the Rs.50 note was worth Rs.50 only! Then the fun started. (Evil smile again)
  • One chap bid Rs.50 for the note. (After all, it was Rs.50 for a Rs.50 note..no-profit-no-loss right?)
  • Then i told the Rs.45 bidder that if he loses, he needs to pay me Rs.45 as per the rules. So, in order to avoid the loss, he needed to win. Naturally he bid Rs.55.
  • Then I came back to the Rs.50 bidder and told him the same thing. He too placed a higher bid at Rs.60 in order to avoid loss. 
  • None of them could afford to be a runner-up, otherwise they would have to pay me the amount of their bid. The bidding frenzy continued unabated.
  • In a matter of minutes, the bidding had reached Rs.210!!! It was then that I had to decide to stop the auction. 
  • Well, the chap who had bid Rs.210 won the Rs.50 note. And the runner-up who had bid Rs.205 had to give me Rs.205. In effect, I sold a Rs.50 note for Rs.(210+205) = Rs.415! Sweeeet!
We all have observed similar things happening to us during investing in the stock market. So what are the lessons we can learn from this exercise;
  • One should become a teacher and swindle unsuspecting students. Its quite profitable. (Ok ok, thats not a lesson to be learnt. In fact, I gave them all chocolates out of the money I collected from them!!)
  • We all fixate and concentrate on un-important stuff and become blind to the obvious. Just like everyone fixated on the signature on the note so much that they failed to carefully consider the trick condition of the auction! While investing, we must give due importance to all parameters and conditions and not get excited or influenced by some single attractive parameter. We wouldn't want to miss out on something important, would we? 
  • We are extremely loss-averse: Our brains are wired in such a fashion that we will do anything to avoid losses. Its a natural human tendency. In the experiment, everyone started with the objective of earning profits, but ended up trying to avoid losses!! The loss aversion of humans plays out well. We have to learn that there is no need to pay more than Rs.50, for something which is worth Rs.50. This was a losers' auction and those who participated were destined to lose. Similarly, in stocks, if one has made a mistake, then one should get out immediately upon recognising it, irrespective of the loss.
Emotions and thought patterns are truly wonderful (or harmful) and it is fascinating to study them. We just had an introduction to some concepts of behavioural finance and i intend to post separately on each topic.
Hope you all enjoyed this one. (Including any students of mine who are reading this!)

Cheers and happy investing!!

24 comments:

Aniruddha said...

Wonderful Experiment!

Keep it up

regards
Aniruddha

Neeraj Marathe said...

:-)
Thnx Ani..
cheers!
Neeraj

Anonymous said...

where is the Rs. 50 note which you signed? I'd be interested in it. With your unique approach to teaching, i can bet your signature on that note will be truly worth much much more.
Best wishes,

Neeraj Marathe said...

LOL...Mr.Anonymous, that is very kind of u indeed!
cheers!
Neeraj

Vinit Shah said...

Nice one and very true......

Sundara Rajan said...

Neeraj

Interesting experiment.

Neeraj Marathe said...

Thnx Vinit and Sundara..
Cheers!
Neeraj

sarada said...

nice one. I wonder what would have happened if 4th rule would have been the first and it would have been a closed auction ? will the behaviour be different if we don't know what the others are bidding ?

Neeraj Marathe said...

Hey Sarada,
As expected, u always bring sumthn interesting to the table! :-)
In this particular case, since almost everyone was fixated on the signature part (everyone thought that the signature was the trick part in the exercise), i dont think it would have made much difference if the 4th condition had been mentioned first..
And ya, i think that the behaviour could be different in case of a closed auction. In the absence of 'bidding frenzy', participants may take more rational decisions. Only one way to find out..by trying this out in another college i teach! :-)
Cheers!
Neeraj

sachin8778 said...

Good one Neeraj!

Neeraj Marathe said...

Thnx Sachin..
Cheers
Neeraj

Anushree Gupta said...

Yes yes...i am a part of this class.... it was Amazing sir!

Anushree Gupta said...

Yes yes... i am a part of that class..It was amazing sir..!!

Neeraj Marathe said...

:-) thank u m'am...gud to hear that u njoyd it..and fortunately for u, u were not among the high bidders! ;-)
cheers!
Neeraj

Anonymous said...

Hi Neeraj,
You said "no one should pay more than Rs50/- for a Rs.50/- note".
I disagree. No one should pay even Rs.50/- for a Rs.50/- note. Why should they pay X to get X ??? And, in the context of the game, if some fool had bid X+1, then the person bidding X would either have to up his bid or pay X for nothing.
If you are with me so far, can you tell answer this question ??? What is the optimal bid that a person should make, given the rules of the game prevailing ???
No prizes (OK, maybe a few drinks, lol, lol) for figuring it out.
Shambo,
Carlos.

Neeraj Marathe said...

Hey Carlos,
Pleasure hearing from u..
To answer ur questions, i agree that ideally, one should pay sumthn less than Rs.50 to get Rs.50. However, in the worst case scenario, one should be paying a maximum of Rs.50..sooo less than 50 is cool, but more is uncool..exact 50 is like room temperature! :-D
Secondly, about the optimal bid..to be honest, i do not think there is an optimal bid..knowing the conditions of the auction, one should NOT BID AT ALL...it is a losers' auction (since i am assuming that there will b plenty of irrational people participating)..so i would keep my mouth shut and say 'jai ramji ki' (in ur words!) to the possibility of making profit here..
Cheers!
Neeraj
(P.S. The 'few drinks' thing sounds appealing!)

Anonymous said...

Of course, one should not bid at all, given the rules of the game.

Or, one should ask the auctioneer (in this case you) to quit the room for a few minutes and then strike a deal not to go above a certain amt, say ideally Rs. 0.50 . Someone starts with Rs 0.25, then someone else raises it to Rs 0.50 and then refuse to go higher. Sooooo, you give up your Rs.50/- and collect Rs 0.75 for your Rs. 50/-
Sweeeeeeeet, indeed :-)

Lessons learnt : 1) Don't become a teacher and try to dupe your students as they will collectively outwit you. Read "Wisdom of Crowds" by James Suroweicki 2) Don't underestimate others. This is a common failing.
"I am an above average driver, looker, etc...all/most others are below average"
Cheers Neeraj,
Carlos.

PS--Drinks anytime :-) You say when.

Neeraj Marathe said...

:-)
Agreed entirely...
well, the purpose of this entire session was not to prove my smartness (i aint smart at all), but to make my students think..
anyways, my students will be more than glad to read ur comment! :-)
cheers!
Neeraj

mikky said...

Interesting....Why didnt u do any experiments like this with our batch..M sure u were scared of the fact that it would have failed:)

Neeraj Marathe said...

O yes m'am!
extremely scared! :-)
cheers!
Neeraj

Raja said...

i would have loved to be in your class. It's teacher's like you who impart the maximum learning for the students.
Enjoyed the post thoroughly!!

Regards
Raja

Neeraj Marathe said...

Haha..
thnx Raja..we have fun :-)
cheers!
Neeraj

Shazia said...

Hi
you left me speechless and hungry for more...
Thanks again
Shazia

Neeraj Marathe said...

Thnx Shazia,
Glad u njoyed it!
Cheers!
Neeraj