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Why flowery narratives around some stocks lead to biases and wrong buying decisions

Retail investors are often overcome by framing and confirmation biases. What are these traits and how do you overcome them?

April 30, 2021 / 11:49 AM IST

I always tell investors that stock investing is 1 percent knowledge and 99 percent temperament.

That is, even after you have done thorough research on a stock and attained all the required knowledge, your score is 1 out of 100. Now, you have to work for the remaining 99 marks.

This does not mean knowledge is not important. Knowledge is the foundation on which temperament has to be developed.

Let’s talk about one such aspect of temperament.

What is framing bias?

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When you form an opinion based on the way the information is presented to you, it is called framing bias or narrative fallacy.

Can you give an example for framing bias?

Coal India Is a well-known company. It contributes more than 80 percent of the total coal production in India.

When you read or hear this statement, the first thought which might come to your mind is, “let me buy the stock”.

Now, let’s say you read another factual statement about Coal India: “The total debt of Coal India quadrapuled between 2018 and 2020.” Now, you might say, “I will stay away from this company.” 

This is called framing bias. We form an opinion about something based on the way the information is presented (framed) to us.

None of the above two statements are enough to make the final judgment call for this company.

Despite debt increasing four-fold, the debt-to-equity ratio of Coal India is very low (below 0.2). Also, despite being almost a monopoly in its industry, Coal India has been a wealth destroyer for investors (so far).

In the last five years, its returns have been (minus) 15 percent compounded annually, and the last 10-year returns have been (minus) 10 percent annually.

Another example: Read the following two statements.

Wabco India (in the business of manufacturing braking products) has more than 85 percent market share.

Wabco India has a return on equity (ROE) of less than 8 percent and price to earnings (PE) ratio of more than 130.

Now you know how fatal it can be to jump to conclusions by just reading one isolated statement.

Also read: Why PSU stocks may never be able to create long-term value for shareholders

What else?

Framing bias can further lead to confirmation bias. Confirmation Bias happens when we form an opinion and then look for reasons to support it.

For example, in the case of Coal India, if you formed an opinion going by the ’80 percent market share’ statement, and then went ahead to look for more reasons to invest in this company, there is a chance that you have already made up your mind to buy this stock and you are simply looking for more reasons to support your call.

This is called confirmation bias. That is, you are already biased towards the company and you are likely to ignore the negative points you might come across about it.

Also read: Avoid these behavioural biases while investing in volatile markets

What should I do?

There are two things you can do:

-Check your portfolio and see if there is any stock that is a victim of framing bias or confirmation bias. If yes, you can do thorough research now. If the research shows that it is not as good a stock as you considered it to be, then you can consider selling it. The good news is that the market is bullish and the stock may fetch you good returns. “Bull Market is a good time to sell your mistakes.”

-In the future, when you read any such statements, especially the positive ones, take it as a good reason to ‘start your research’. It is not a good enough reason to start investing in that company. Just ensure that you are not a victim of confirmation bias while doing your research.

I believe that being successful in stock investing is more about life skills.

Also read | Sensex at all-time highs: Should you exit your investments and re-enter at lower levels?

Here are some points to consider.

-How often do you judge someone based on the story you heard about them (framing bias)?

-And how often do you wear a filter of opinion for these people and then look for reasons to support your opinion in all their actions?

If you read about successful stock investors in detail, you will realize that their life skills are as impressive as their stock-picking skills.

Disclaimer: The stocks discussed in this column are not recommendations. The writer does not own any of these stocks in his portfolio. 
Anupam Roongta is a SEBI-registered research analyst. He blogs at www.anupamroongta.com
first published: Apr 30, 2021 11:49 am

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