The Tycoon Report

Everything's Relative: How Not to Get Suckered Into Anything

Thursday, August 20, 2009 | Bob De Dea

Traditional economic theory is built upon the premise that the decisions we make are justified, based upon fundamental values, likes and dislikes.

Traditional economic theory might just be wrong.

Take a look at the factors that influence your decisions -- from how you add/remove positions from your portfolio, to where you choose to live and how you spend your money -- and you might be surprised at how your perception influences value.

Fair Value is in the Eye of the Beholder

Did you know that people who move from one housing market to another tend to think in terms of the market they just left, not in terms of the new market?

In fact -- regardless of their ability to pay for an equivalent home, taxes or any financial considerations -- a family who moves from an inexpensive market (e.g., Poughkeepsie, N.Y.) to an more-expensive one (e.g., Pittsburgh, Pa.) is more willing to live in a smaller or less-attractive home than to shell out more money than they think they should.

Likewise, those moving from an expensive market (e.g., San Francisco, Calif.) to a less-expensive one will more than likely spend much more than locals would to get the equivalent of a mansion in the new neighborhood.

Why?

Because, my friends, EVERYTHING is relative.

Optical Illusions and the Mind's Eye

I'm reading this great book, "Predictably Irrational" by Dan Ariely, and it's changing my perspective on things and helping me immensely when it comes to tried-and-true, well-worn ways of thinking about the world we live in.

So in this new Tycoon Report article series, I thought I'd take what I'm learning and apply it to the market, to garner some insights into my own behavior and to keep from being suckered by the forces at large. Hopefully you'll find it useful as well!

Take a look at the familiar optical illusion below:

You've all probably seen this before, so you know that the two middle circles are exactly the same size. It's the mind that sees each circle relative to the surrounding circles.

"But that's a trick of the eye!" I hear someone saying.

True, but we don't really "see" with the eye (if we did, what we see would be upside and backwards).

What we see is interpreted by the mind (the pupil is a hole to the brain, after all). And the truth is that we think in the same way.

Two more examples:

1] Which of the following offers would you sign up for?

A leading financial magazine offers three subscription choices. Here is how they are presented:

• The one-year Web subscription sells for $59 and includes online access to all articles published since 1997.
   
• The one-year print subscription sells for $125.
   
• The one-year print and Web subscription sells for $125 and includes both the print version and online access to all articles published since 1997.

Most people, when presented with these three options, will pick the combination print and Web offer. After all, it's like getting the online subscription for free, isn't it?

When presented with only two options (the middle option gone), however, the majority of people will choose the $59 online subscription. Without the third option to compare to, the cheaper subscription is more-attractive.

And, I can say with near-certainty, they don't sell ANY of those "print-only" subscriptions!

2] When you go out to eat, do you order the most-expensive thing on the menu? How about the second-most-expensive?

In fact, hardly anyone orders the most-expensive item. But the second-most-expensive looks like a bargain in comparison and it sells quite well. And restaurants usually make that item from ingredients that cost less, so that they make more money on it than they would from the most-expensive!

What's going on here?

We are using the most-expensive options in each case (e.g., the print-only subscription, the steak tartare) as an anchor in our minds.

"I would never succumb to such tactics," another voice somewhere is saying.

But we do the same thing with our investments.

The First Impression Imprinting is the Most Important

No matter what the fluctuation of the price of a security during the course of the day or the week that we've been tracking it, it's the price we pay that acts as the anchor for the future action of that security.

If we start losing money, we think, "It'll come back up on a rebound and then I'll sell it just to break even."

And guess what? It's the first anchor that sticks with us.

How many of you have friends that talk about the price of Apple (AAPL) in 1990 or the cost of gasoline in 2001 or the price of bananas in 1980? (OK, that  one's my mom.)

The kid who first filled up a gas tank in 2001, when the price of gas was $1.40 a gallon, now dreads even thinking about driving to the gas station with gas around $3 a gallon.

On the other hand, those of us who remember the expense of that first DVD player are thrilled to be able to replace our old models so cheaply!

How This Affects Your Trading

There's a phenomenon known as "herding" that happens with groups of people. It's when we assign "good" or "bad" to something based on other people's reactions to it.

"I'm going to buy Apple because, in the same day, three of my close friends said that they were buying Apple!" or "I know somebody who got burned buying this or that stock so I just stay away from them in principle."

But there's also a thing known as "self-herding," where we convince ourselves that something is good or bad in its own right because of a singular past experience.

"I've had great success in trading the Market Vectors Gold Miners (GDX) Exchange-Traded Fund instead of the SPDR Gold Trust (GLD); it's treated me well, so I'm sticking with it."

Sometimes our ideas about a stock or a company or an industry are not based on reality, but instead on some perception we formed of them at some stage for some reason (or no reason).

Think of it as a sort of imprinting (like the goslings who attach themselves to the first thing they see, whether goose or dog or human).

Before You Pull the Trigger (or Plug) on Your Next Trade...

When we find ourselves stuck in a way of thinking about something or repeating behaviors without knowing why, here are some questions to ask ourselves:



The point behind this exercise is that we tend to think, as economic theory proposes, that each decision we make is justified and based upon fundamental values, likes and dislikes.

In reality, oftentimes our successive "decisions" are merely influenced by one initial decision, often arbitrary -- and often made so long ago that we don't remember making it.

This "prime decision" has wound its way into every similar decision since then, and will continue to thread itself into our future decisions for years...

...Unless we break the cycle with our awareness.

Going back to our real estate example, one way to overcome the tendency to think in terms of the old neighborhood instead of the new is to rent a home for a year before buying into the new market. This puts things in perspective and gives us a solid foundation from which to enter the local housing market.

You might not want to wait a year to invest in a stock or ETF that treated you well in the past, but definitely take a step back and determine whether it's a good buy for reasons other than a positive experience in the past.

When we pick up this series next, we'll look at manipulating supply and demand and the true cost of those free offers.

* You may think texting is indispensable. But is it really? You can send messages to cell phones from your computer or merely dial the number and leave a voice message. And by extrapolation, do you really need the latest and greatest gadget or is it a status symbol of sorts?




Bob De Dea
Guest Contributor
The Tycoon Report