Experiential Learning : Fallacies of Human Mind - I

After having spent significant time of my short career on the quantitative aspects; I was intrigued by behavioral science and so sometime a year back I took course by Prof. Dan Ariely on this subject. I found course to be quite insightful and practical. Since then I have been consciously trying to recognize and overcome common behavioral mistake in my decision making process. I must confess that my success ratio is pathetic but now I am at least aware of my mistakes. As part of my experiential series, I would like to introduce few concepts I learnt during the course with examples from non financial world and then elaborate on my experience from the investment side.

‘Human mind likes to select default option and therefore decision making tends to be more default. This issue is exacerbated as complexity (option) increases. Default option is not always bad or always good. It is just an option which is easy for our brain to select ’. I have always enjoyed solving complex problems and therefore I took time to accept this. But now I am able to appreciate the same over period of time. Marketers exploit this behavior to make us buy stuff which they want us to buy. For example cell phone manufacturer sells phones under different brand name with almost similar specs at similar price that it is difficult for buyer to make rational decision. In such cases, instead of buying based on ones need, buyer tends to buy stuff that is sold to him. This is because mind selects default option instead of choosing right one from the many available options.

On the investment side, this problem is even more difficult to recognize. We spent so much time on selecting right stock/investment so as to beat the market returns but once the investment is made then our behavior moves to default option. Though every trader would agree that once the position is marked to market on previous day, holding on to the existing position is similar to taking fresh position but very few traders put that to practice. We have tendency to continue with default option that is to hold on to existing position. That's the reason of the industry practice of having stop loss; to force the trader to think of his existing position. So many times in past I have exhibited such default behavior while trading and in fact still continue to do. For me, ability to exit an existing position is still a challenge which I continue to face but now I am aware of it and working on it.

This concept applies to the quant world also. Industry still continues to use archaic models that assume normal distribution of returns irrespective of market behavior since it is more familiar to them and hence is their default behavior. VaR continues to dominate risk management world rather than mix of complex stress scenarios which can quantify tail risk also. Management still needs one simple risk metric even though it may be inadequate under stress scenarios. Only change post crisis is recognition that these models may fail. In era of negative interest rate, CAPM still continues to be base model. Inspite of ballooning deficit, US still remains standard for risk free rate. And the list is endless…

This concept also applies to every human being when s/he makes the important decisions of their life. If I look back today to see how the most important decisions of my life were made then I feel lot of them have been influenced by this default option especially when stakes were high. Just take few minutes and ponder how you made your most important decisions of your life. Most of us must have been influenced by this default option. I have currently no standard method or process which helps me avoid this pit fall except that I now recognize the issue. My way of overcoming it is to reduce the available options and then consider default option as unviable and then let my grey cells identify second best option. Then problem is reduced to evaluation between default and second best option just selected. Still it continues to be challenge to ensure rational decision making. Any suggestions to handle the issue better?

New India : Post Demonetization ?

Whether you like him or hate him, you have to laud Mr Modi for his courage to take bold decision that can disrupt the society/nation. There have been many business leaders in recent times who have adopted disruption as model to change the industry dynamics but very political leader have adopted such model for governance.  It is double edged sword and not many are willing to risk so much when the stakes are so high.  Before you carry any impression of this post being the diatribe by one of his staunch followers, I would highlight that I only acknowledged his courage to take such bold decisions. Whether the decision is good or bad that time will only tell us but it will definitely have far reaching impact on our society.  I have attempted to put across my objective assessment of the event and its possible consequences without taking ‘for or against’ view. 

East Asian crisis is said to have imprinted financial crisis fear in minds of the people living in those countries at that time and hence for years later they have preferred to save rather than spend unlike their western counterparts. This fear led these countries to maintain much higher reserves as safety net for any future crisis. Similarly in India, high inflation observed in last decade has led to erosion of wealth for savers in India and this has given rise to new generation of spenders. I believe demonetization has potential to have such behavioral change on our society and therefore have tried to focus such long term effect rather than taking myopic view that focuses only on immediate consequences.

Greed and fear are two emotions which determine large part of people’s behavior when it relates to money management.  Current demonetization of high value currency notes will immediately alter the current equilibrium of these emotions in people. People at large seem to have overcome the fear of corruption/black money and it is the greed that seems to be driving their behavior towards current form of society. Years of inaction against corrupts/black money hoarders has reinforced the moral hazard.  Like all moral hazard problem, everyone knows it exists but don’t know how to avoid the same. Mr Modi seems to believe that his decision will end this moral hazard issue in the society. He is trying to make it difficult for corrupt people/black money hoarders to avoid erosion in their wealth by his policy decision. Hypothesis here could be that the pain such people will go through while losing their wealth which they have always believed to be theirs would be immense and would prevent them from hoarding black money in future. The consequences they will face will serve as deterrent for others in the society to commit on this path of corruption & black money. Also people who have paid their taxes on time will get pleasure of seeing the pain of others who don’t fall in their group and would reinforce their FEAR in future. (In fact it is this pleasure which led to initial positive assessment of his decision). If this succeeds then we may see an end of parallel black economy that has existed for years. It would make it difficult to fund terrorism, bribe officials etc since source & use of funds can be known easily. Already news have been flashing of the difficulties naxals are facing to exchange their loot and they may also see erosion in their wealth. Here FEAR is expected to bring about positive change in people.

Let’s try to take contrarian view about the same event. The high valued notes earned by the people have suddenly become worthless instills FEAR about monetary currency. The current monetary system exists mainly because of the people faith that it will be honored without much hassle.( Of course in current form, one can deposit or exchange currency notes up to certain limit but it is certainly not hassle free.) If people start having doubts about high value currency notes then in future they will not like to accept it or keep it as saving instrument. Would they then prefer gold over them in future since in our society gold’s acceptance has never been questioned yet? Further its global acceptance provides additional comfort for liquidation and removes one’s dependency on nation central bank. This can lead to situation wherein savings would not get channelized into useful development but into gold hoarding. Of course government and central bank may have other means to change this behavior but it would take years to acknowledge and act on the same.  Lot of black money hoarders were believed to have rushed to buy gold, USD post demonetization announcement. Of course they intended to convert black money into gold for future use. But will this immediate gold buying end once these two months are over? Answer could be NO!!! Government would like to believe it will create enough incentive to move people to digital currency. Phew, new disruption model for country where literacy rates are so low; where gullible people have been duped so many times in past that they don’t even trust the banks.

Black money incentives risk taking, discretionary spending among the people. Demonetization will lead to overall decrease in wealth in the society as such and would either strengthen central government or central bank balance sheet. Even if government increases its expenditure, it will take time for this wealth to be accumulated by the society large. Now what do we expect from such society which witnesses mass wealth (legal/illegal) destruction due to act of government? FEAR ? People would spend less, less corporate gains, lower number of new jobs etc. Coupled this with highest population in age of 20-30 years, global slowdown & protectionism and rising terrorism imagine the potential social unrest it can create in huge nation like ours.  In both above cases, FEAR seems to have negative consequences for the society.

The actual consequence of this event may lie in between both the extremes described above.  It is very difficult to gauge people’s behavior and predict the future especially when population is more than billion. But it is certainly one of the exciting times to be in India to experience the same.  Government and its policies will definitely have key role in influencing people behavior. But I firmly believe it is us and our behavior that will shape up the future of this society and government response will be guided by them. So let’s keep our emotions in check; objectively assess situation with open mind post immediate fallout before forming any firm opinion about the event. 

Pricing Woes for Airliners

We saw extensive coverage of Kingfisher Airlines mounting debt for last two weeks and it still continues. I don’t understand whether news are being covered because of its promoters or there is genuine concern about the company and industry. Sometimes it feels similar to ‘run on the bank’ like syndrome and few sadist just waiting to celebrate death of the company. The real problem/concerns for the company/industry seems to be lost in midst of the expert opinion by analyst/leaders.

Lot of bullshit has been written on predatory pricing by the players which is killing the industry. But sorry people I beg to differ here. We need to answer simple question here? Who are the competitors? Are the industry players competing among themselves? Or are they replaceable? Let me go back to history. Indian aviation sector became attractive, once the burgeoning middle class started using the service, which was made available through low cost carrier like Deccan. Other important trigger was the growth of the corporates especially in service industry like IT. Let us consider each of this segment and understand their possible action in case there wasn’t predatory pricing by the players as termed by the analyst. Corporates in that case would prefer to use the services of teleconferences/video conferences which are made available at much lower cost. Further most of MNC are already used to such services when interacting with their overseas clients. Also during the recent economic crisis lot of corporates did transition to such services. So increasing price would certainly have negative impact on the volumes in this segment. It may be countered with argument not all cities/towns might have such facility but then do these cities/towns have decent airport and volume to make that routes viable for any airlines? Second important segment was middle class of India which has always been price sensitive.People in this segment still check the fares of second/third AC railway tickets and perform the cost benefit analysis. So here industry players aren’t competing among themselves but with other industry which is highly subsidised and can afford to run in losses since it intends to make up by other services. In such a market dynamics I don’t see any other option for the aviation sector but to keep price low especially in high inflation scenario.

Before applying any futher thoughts on pricing let us analyze the cost structure of airlines.To add to all pricing woes, the most important cost for the sector is aviation fuel whose prices have been volatile and it needs to be imported. The prices are function of the global demand, not the domestic demand and are decided by few countries that have huge resevoirs of oil. No company in industry can decrease this cost by backward integration nor does the law permits them to manage their own imports.So the cost is subject to not only the volatility in commodity market but also foreign exchange market.Further the companies have high fixed operating cost and in case of low volume they lead to high losses. Not to forget the seasonality factor & regulator who seems to keep close watch on the prices. Further weather & operational inefficiency of the security/airport staff also impact the volumes for the industry.Shortage of qualified pilots & skilled cabin crew leads to additional cost for the industry.It is very important to appreciate all these factors because careful assumptions are to be made to determine cost per traveler/seat on the route. Without knowing the cost no pricing strategy can be devised. The complexity in this case is that assumption are not only required on demand/supply side but on aviation fuel, seasonal effect etc. Any variation in these assumption can have huge impact on pricing strategy.

So on the one hand industry is competing with subsidized railways and the new technology which curtails their pricing power and on the other hand the cost structure is dependent on the global economic factors which are beyond the control of the industry. Pricing in such scenario can be very tricky. Aviation industry is known to have used demand pricing strategy across the globe wherein the prices increases as demand increases. However in India regulator has put some caveats in place to avoid cartels. Further globally the industry doesn’t face same challenges as in Indian scenario. Is this time to rethink pricing strategy? What can be learnt from shipping industry/telecom industry? I have no answers to the pricing woes but I bet its one of the most challenging business problems. We have just scratched the issue here with minimal knowledge of the industry. But certainly it has got my grey cells working. In fact next post I would like to focus on the financial woes of industry & KFA especially.Maybe it might throw up some answers then!!