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Sunday, April 8, 2012

Are you emotional or logical in your investment decisions?

Should you be emotional or logical in taking investment decisions? That is an easy question. Every one is, or should be, logical in their investing decisions, right? Wrong! Even seasoned investors with 20 years experience in the stock market make silly mistakes by letting their ‘gut feel’ overrule their own logic.

This is what makes making big money in the stock market such a challenge. How can you overcome the mental impulses that lead to poor decision making? It takes patience, discipline and several years of effort to reach a stage where one can be dispassionate enough to buy or sell a stock purely on the basis of logic, and not get swayed by what is happening in the market or in the country or in the world.

One way to approach the problem is to have a plan. First a financial plan where you set out short-term and long-term goals for achieving different commitments such as buying a car, an apartment, children’s education, etc. The financial plan will lead to an Asset Allocation Plan, where a certain percentage of your portfolio gets allocated to different asset classes, like stocks, fixed income, real estate, gold.

Of course, you should not take my word for it. Assess if you have a problem at all – the ‘problem’ being emotional decision making while investing. So here is a little and apparently easy test that you can undergo to determine if you think emotionally or logically.

Shane Frederick of MIT’s Sloan School of Management introduced a three-question Cognitive Reflection test in his paper ‘Cognitive Reflection and Decision Making’. The three questions – modified for an Indian readership – are:

  1. A bat and a ball costs Rs 110 in total. The bat costs Rs 100 more than the ball. How much does the ball cost?  Answer: Rs ……..
  2. If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?  Answer: ……….minutes
  3. In a poultry, eggs are being collected in baskets. The number of eggs in a basket doubles every minute. If a basket gets filled in 48 minutes, how long will it take to fill half the basket? Answer: ……..minutes

Please take a sheet of paper and a pencil and do not take more than 30 seconds to answer all three questions. Then take a minute or two to reflect on your answers. Did you get the answers right the first time? Did you get the correct answers after thinking about the questions a bit more?

Don’t feel bad if you didn’t get correct answers the first time. After testing several thousand people, Frederick found that less than 20% got all three answers right. Among professional fund managers, traders and analysts less than half managed to answer all three questions correctly!

Frederick also found that those who do well on the cognitive reflection test tend to be more patient in decisions between smaller sooner rewards and larger later rewards.

(Note: You don’t have to send me the answers. This is supposed to be a self-assessment test. But your comments are most welcome.)

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How to reallocate your assets

3 comments:

Bhaskar Jain said...

Good one Subhankar da.
Q3 is asked in interviews and they substitute lily with bacteria in test tube.

Subhankar said...

Thanks for your comments, Bhaskar.

Similar questions appeared in IBM's aptitude test for programmers many years ago.

kumar shah said...

useful post