Here is a quick test to determine your Investment Quotient (IQ).
Stock A at Rs.100 has a 7% chance of dropping below Rs.100 in the next five years.
Stock B at Rs.200 has a 93% chance of gaining from this price level in the next five years.
Which is a safer investment bet–Stock A or Stock B?
In case you picked Stock A, you are being very smart or foolishly brave.
In case you picked Stock B, you are one among the many investors who fall for a very common mental illusion caused by “Framing” according to behavioral scientists.
In simple words, “Framing” stands for human fallibility to decide based on the way information is presented.
Let us revisit the IQ test
Both the stocks have an equal chance of falling by 7% from their current levels. After all a 93% chance of Stock B going up means it has a 7% (100-93%) chance of falling.
In case you chose Stock B, you are not very different from the average man on the street who prefers Stock B to Stock A just because it is presented in a manner that makes it appear more appealing.
As humans, we always make approximations in our decision making process. No wonder, we are all on the lookout for easy ways to make money. One of the approximations we do is to figure out departures from a base case described rather than calculate what is the eventual outcome.
So in this case, the description of Stock A’s 7% chances of falling turns out to be the base case and the second option is evaluated against this. So a 93% chance of rising looks good for Stock B. The mind does not grasp the implications of a 7% fall and 93% rise in the first sweep!
In case you managed to get the above test right in one sweep, great show! But be sure to stay away from the many more that abound.