Happiness hedging and other biases

Kahneman has popularized the concept of anchoring and narrow framing more recently. For those who haven't read his recent book (Thinking Fast and Slow), let me elaborate briefly.

Anchoring is the tendency of individuals to base estimates or predictions on previously perceived baselines levels. For example, when people in the US were asked what percentage of African nations are a member of the UN, the initial question was framed as - "more or less than 10%?" and on a different occasion, when people were asked "more or less than 65%?", the responses were drastically different. The researchers found that people anchor themselves to the benchmark provided in the question without evaluating whether it is accurate or not. Investors make the same mistakes and often anchor themselves to the current state of the world without evaluating the possibilities without the anchor.

Similarly, Narrow Framing is the tendency of individuals to isolate a decision or choice from the rest of the world or from the broader class of phenomena to which that decision belongs. Life insurance is a good example here. People might say that, “I feel pretty good right now, I’ll take out a policy when I get sick”, not realizing that policies at that time might cost significantly more than now. In an investing context, investors might use a limited set of metrics, obsess about changes in prices of a particular stock etc., and this can lead to significant losses.
This mostly happens because trading situations often become complex and the number of factors changing multiply too fast to keep up with. Even worse, investors may find it difficult to change an anchored mindset combined with narrow framing only to realize huge losses on their bets.

Happiness hedging is where investors also tend to make arguments such as ‘I’ll sell some puts now and collect the premium, and if the puts get exercised, I’d be happy to accept the price on it then”. Unfortunately, this idea is based on the hypothesis that the world will be the same on the day of the exercise as it is today. It ignores the possibilities that the company might go bankrupt, country of origin of the company might have a currency default, or there are paradigm shifts in the company’s external environment.

Lastly, hard-won reputation bias is based on the assumption that reputational effects in business relationships will always persist. Take for example the private equity business; even if a deal were significantly underwater, private buyers and PE firms wouldn’t walk away from it since doing that would damage their reputation and would make doing future transactions harder. There have been several examples where firms took part in transactions that weren’t just unprofitable, but only done to maintain ‘reputational capital’. Some might argue that from a game theoretic standpoint, it makes sense to maintain reputation and participate in ‘repeated games’. But whether the transaction was worth a future revenue stream, or would it have been better to walk away from it, is a topic of different discussion.
This concept can be extended to other financial and trading relationships as well, for example, in merger-arbitrage situations, where these factors, i.e. the degree to which a deal is underwater, the likelihood of future M&A deals, and the importance of reputation are highly correlated.

These value destroying biases have been prevalent for decades, but have come to light only recently. Is it possible to invest while taking them into account, I’ll leave that for you to decide.
Invest well.
Read more: here, here, and here.