Tuesday, May 6, 2014

Investing Psychology: Fairness Means Willingness To Reciprocate

Fairness has always been a black and white concept to me. However, I've found that fairness is a difficult concept to many people. Fairness means different things to different people. This can sometimes be a problem since the idea of what is "fair" is open to interpretation. This article will focus less on numbers and accounting and more on psychology. Understanding fairness is of utmost importance if you ever want to become a successful investor. After all, buying something below fair value means you are getting good deal. Buying something above fair value means you are getting ripped off. Intelligent investors are in constant search of good deals. Knowing what fair value really means is an absolute requirement to beating the average, or beating the market.

I'll start off with the statement that most people are biased. If you do not believe that you are a biased person, you're probably a biased person. People by nature are selfish. And it is not a bad thing. Evolution favors people who are selfish, because people who put themselves first live longer. This bias tends to corrupt our definition of fairness. It secretly makes us believe that we need to benefit for a situation to be fair. People are full of contradictions when presented with different scenarios, depending on what kind of biases that they have.

Let's try an experiment. Do you believe that it would be fair for students if they could borrow money for college at 1% interest? If you said yes, then would you be willing to lend money to students for tuition at a 1% interest? Most people who said yes would say no at this point. The only people who say yes to both questions tend to have no money to lend (or will have no money very soon). This should be a hint that 1% interest is not fair, and that you answered the way you did because you were biased. If it was fair, you should be equally happy to be on either side of the transaction. Your unwillingness to reciprocate is a contradiction to your belief that 1% interest is fair.

Let's try another experiment. An XBOX One currently costs $400 dollars. Let's say you are one of the many people who bought one. Now, imagine that you won a raffle and you now have a second one, which is useless to you. If someone on Ebay was willing to pay you $400 for it, would you sell it? A pragmatic person would say yes. Even if you needed a backup XBOX, you could probably buy a new one later for cheaper. This is an example of a fair transaction. Both parties are willing to be on either side of the transaction. Your willingness to reciprocate is confirmation that you really believe $400 is a fair price.

A fair transaction is reciprocating. You should be willing to accept either side of the transaction. As an intelligent investor, you should never want to engage in a fair transaction. You can't get rich like that. If a stock is at at price which you think is fair, you should have no interest in it. You need to be the guy who is waiting for that XBOX to go on sale for $350, knowing that it is worth $400 at regular price. You need to understand that $400 is fair price, and $350 is a bargain. This sounds like common sense, but for many people, this all goes out the window once we're talking about stocks.

To become successful at investing, you need to understand what fair means, but act selfish. Most people are selfish but do not understand fairness. This is a problem because there are many opportunities to get ripped off. We've all had our days when we've purchased a stock thinking we were invincible, only to find out a week later that we've really overpaid by a lot. In retrospect, the people thinking it's fair to borrow at 1% interest but unwilling to lend at 1% interest have a very important trait of a successful investor.

For the technical analysis traders who want to buy / sell a stock if it breaks resistance / support, in the grand scheme, it's like buying an XBOX for $399 and thinking you got a great deal, or thinking $401 is a rip off. You were willing to buy or sell essentially the same price after a rounding error, meaning you were willing to make a transaction at a price which you yourself considered fair. This is not intelligent investing. This is a great example of not understanding what fair means, and hurting yourself in the process. If you were so willing to take either size of the transaction at prices so close, it means you were not getting a "good" deal on either side of the transaction. You were getting a fair deal, and you won't be getting rich from it.

I have to admit that I am biased as well. I frequently describe a stock as fairly valued because it's near the intrinsic value that I've calculated. However, this is far from "fair". My intrinsic value calculation implies that the investment should grow at 15%. In situations like these, me saying "fair price" really means "incredible deal for me". Fair is bad for investing. Think about what price you are willing to buy the stock at, and what price you are willing to sell the stock at. If the two prices are too close to each other, it means you're not getting a good deal on either transaction. Most things in life are just rounding errors. Make sure your trades aren't one of them.

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