Monday, November 27, 2006

Analysis, Paralysis and Decisions...

Truth - The more choices people face in life, the more likely they are to simply do nothing.

The above can also be encapsulated in a simple phrase - "Paradox of Choice"

This phenomena which was presented to us by Kahneman and Tversky explains a lot of irrational behaviour which arises in the stock market. The simplest way for a broker to make his client buy something is to tell him about this ONE big wondeful story that would get the client "wet". Ever wondered why the broker never tells his client about 4-5 equally enticing stocks. Simply, because in practice evolution the brokers have picked up this skill that too many choices will make sure that they end up confusing their client and not earning any commision.

Ever tried buying a new cell phone. The choices are galore, the models are breathtakingly beautiful, and almost everything has most of the features but NOT ALL the features. I recently tried buying an instrument and ended up confused after a day of searching for the "perfect" model for me.

Humans by their very nature are an optimising rather than a satisficing species. We try to optimise everything thing that we do in order to get the optimal result. This can be disasterous sometimes, if we arent focussed enough

More later...

Probability and Life...

There is a lot of difference between subjective judgement and impersonal probability. And because of the way our brains are "wired", we fail to decipher this difference in real life.

Many a times we take life to be too harsh or unfair to us. Psychological fragility explains our tendency to feel more aggrieved when an event which our non mathematical brain judged as unlikely occurs.

As behaviourial economists have noted, people tend to exaggerate the likelihood of events that are new, emotionally stirring, dramatic, or concrete, and tend to underestimate the probability of events that are old, emotionally neutral, boring, or abstract.

As humans, we use frames of reference and for each and everyone of us, these frames are different. These frames define our "view" of the world. And this is slighly tilted in favour of the right side of our brains. We would rather chat with others than try to figure out the patterns and probabilities around us. Then, there is the fat tail which throws a spanner in a lot of finance based theorems.

For example, all the new finance theories that I was taught were based on the normal distribution curve or the bell curve, but what the Professors did not care to tell me was that the world does not function this way. It is too messy and too complex and very, very inter connected.

Now, I am very lucky that I slept through most of the finance classes. Mark Twain's words come to mind - "I was brilliant, education ruined me"

Wednesday, November 01, 2006

Arbitrage is intellectually stimulating...

In economics, arbitrage is the practice of taking advantage of a state of imbalance between two or more markets: a combination of matching deals are struck that capitalize upon the imbalance, the profit being the difference between the market prices.

In the stock market arbitrage comes in very many varieties -
a) Buyback Arbitrage
b) Delisting Arbitrage
c) Mutual Fund Arbitrage
d) Difference between BSE and NSE or other exchanges
e) Merger Arbitrage
f) Demerger Arbitrage
g) Litigation Arbitrage

That just about covers what I know of.

The best part about an arbitrage is that it pits you against intellectually superior people working in Hedge Funds and other investment houses. You are forced to raise your level of performance just to keep up with them.

You have to look at the same scenario as everybody else and come out with the best Highest reward - Lowest risk solution to the problem. In case, you are not able to, like poker, just walk away.

The need for this arises in sustained bull runs for most value oriented individuals/funds, when pickings are slim and the probability of buying anything cheap declines substantially. You have to be on the lookout all the time to avoid the "value traps" also.