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!!