Case A:
A bet in which you will surely loose 50 Rs. (100% chance of loss)
A bet with 25% chance of Loss of 200 Rs, and 75% chance of Zero Loss
Some people select choice 1, other select choice 2. What have you selected?
Well, 98% of the people select choice 2 – so if you have done so, Congratulations – you are with the majority. But is majority always right? No, not necessarily, and not always. The psychological reason why more people select option 2 is because there they see a 75% chance of Zero Loss. They believe that there is more chance of saving a loss (75%), and it is better than a sure (100%) chance of loss of 50 Rs. The first illusion that comes to mind is that it is wise to take a 75% chance, rather than a sure loss.
However, mathematics works in its own ways. If we take the VALUE of the above two choices, we have the following:
100% * (-50) = -50
25% * (-200) + 75%*(0) = -50
Basically, what this means is that both the options are exactly the same, as far as mathematics is concerned. If someone asks me how much I will be willing to pay for entering this bet, I’ll say 50 Rs for both.
However, our psychological biases force us to look only at the things that we perceive are good, not necessarily the once that are really good. We do not know how to value an investment or a product, the only thing we look at is who is offering the product (a reputed investment bank, fund house or insurance company), who all are talking about and taking the policy (our colleagues, friends, relatives, even agents and brokers) and how has the product done in the past. What we forget is that there MAY not be any relationship between the efficiency of the product with its popularity, and with its past results – like a Mutual Fund performing better in the past does not guarantee similar returns for a coming year in the future. We tend to base our judgments on these factors completely ignoring the realities.
Let me give you another set of options:
Case B:
Let’s say you own a motorbike which you really love. There is a 25% chance that your motorbike will meet an accident and will require repair cost of 200 Rs, while there is a 75% chance that the motorbike will not suffer any accident. So here are your two choices:
Pay Insurance premium of Rs. 50 to avoid paying repair cost of your motorbike
Suffer 200 Rs. loss to your motorbike repair cost (25% chance) or Zero Loss to your motorbike (75% chance)
Which one will you choose?
Again, as in the previous case explained in the beginning of this article, majority (98%) of the individuals choose to take option 1. Hardly a few will select option 2. The fact is both these options again value to the same price.
Now comes the most interesting part: Compare option 1 of Case A and Case B – are the 2 options any different? Option 1 of Case A mentions a sure loss of 50 Rs. while that of case 2 mentions paying an insurance premium. Are they two different? No – they are exactly the same. Similarly, option2 of case A and B are also exactly the same. Yet majority of individuals (including me) end up selecting option 2 for case A and option 1 for case B. The only difference in case A and case B is about the presentation. The same concept is presented in 2 different forms so we end up making 2 different choices. This shows how wrong we are in our perception.
Insurance policies are designed taking advantage of this psychological bias – we don’t see the reality, we end up taking our investment decisions on what is presented to us, not what we need or understand. The job is very well done by agents and brokers. They may not be aware of making profit calculations, or in judging whether this policy is good or bad for the customer, but they gradually become experts in taking advantage of psychological biases and mentioning about the circumstances in which we may need a particular policy.
As salaried individuals or businessmen or doctors or other professionals, we find it difficult to devote time to understand these financial calculations. The interesting irony is that these financial decisions are made to secure our future financially – and while buying such products we are the least bothered about the nitty-gritty. Ultimately, it’s human nature – the only thing that can be done is to educate ourselves and use some more presence of mind. We work so hard to earn our money – we leave our money decisions to agents and well-wishers! We get trapped with what is presented and ignore what is right and what we want.
Here’s another common example:
A person will drive in his car for 12 Kms. to buy a DVD Player which was initially priced at 25$ and now being sold at a discounted price of 15$ - he will buy the DVD player that he does NOT want – but is more interested in saving 10$. However, the same person will not purchase a winter coat (that he may really need) available in his neighboring shop for 300$ offering a discount of 10$. The problem is with the so-called “Reference Point”. A 10$ discount on 25$ value looks more in value for something that you don’t need, but the same 10$ discount on an item that you definitely need will not look worth on 300$ price. We tend to look at the percentage basis. 10$ on 25$ is 40% discount, while 10$ on 300$ is only 3.33%. People may already have a DVD player at home, but just because it is offered at a HIGH Reference point discount – they buy it – thinking that they will gift it to someone else or use it later. All that happens is that we end up buying something that we don’t need and avoid buying things that we really need.
However, from the point of view of the seller – he is offering a huge % discount on DVD player because something (15$) is better than nothing. The seller may know that a more advanced version of DVD player may be coming in the market very soon, so the current player will be made redundant. It’s better to sell it off at a lower profit (or even at a loss) to extract something, instead of dumping it in the godowns for no value.
This is exactly what goes on in the investment and insurance business. You become more prone to such marketing gimmicks. The insurance companies put up huge hoardings and place big adverts in the newspapers and television channels – all aimed at disguising the product to be excellent. We tend to ignore that this product may not even fit into our requirements, yet we end up buying them.
Very often I see a 50% discount on sale of 1 Kg. pack of cheese, butter and other dairy products in my local superstore. I’ve seen people blindly grabbing these big size packs of these products – while all they need is hardly 100 or 200 gms pack. The reason for sale is because the expiry date of these products is coming near. If no one will buy it, it will be a 100% loss for the seller. Sell it at 50% discount; atleast the seller gets 50% of the money. What really happens is that after purchasing the cheese in bulk, it may not be possible for the consumer’s family to consume it before the expiry date. A significant portion goes in the garbage bin, nullifying the entire discount. But we tend to buy impulsively – just concentrating on discount.
Another similar experience I had in Big Bazar. It was Saturday, and there was a lot of crowd in Big Bazar. Suddenly, a salesman rings a bell, and announces,” For exactly 1 hour from now, the shirts in this segment will be offered with Buy 2 get 2 Free offer. The offer will end in just 1 hour”. Immediately, people jumped into the shirts section. They were trying to locate the 4 shirts that they can buy – with a tension that they have only 1 hour to select and may be that the best shirts will not be available for long. All that happened was people ended up buying shirts that they didn’t really need, that too 4 of them. The price may have been discounted, but the sale of 4 shirts ensured that big bazaar managed to sell its products. Nothing but IMPULSE MARKETING.
The same goes on for selling insurance products and investment policies. We tend to take decisions instantaneously. We never take time to analyze and IPO or a NFO – just that the IPO or NFO is opened for 3-4 days, we pour in our money. Same goes for insurance policies which are sold at the financial year end –with the tax-saving keyword doing the magic (as I’ve explained in one of my previous articles).
Sometimes, the agents are even willing to give cash from the portion of their commission. Most of the times, these cash offers are made for policies that require a long term commitment from the investors. All that is required by the insurance company and the agent is that the policy should be sold, the customers should commit for a long term – that is what makes LIC the biggest player in the Indian stock market.
Other articles
No comments:
Post a Comment