Tag: Thomas Gilovich

31 August, 2016

Why insurance agents don’t talk about death

rupee

One of the first things life insurance agents are told while being trained, is to not talk about death, while selling an insurance policy.

And that perhaps explains, why the agents tend to talk about everything from the prospect of good returns to tax savings that can be made by buying an insurance policy.

People don’t like being told that they will die one day. And in case of an untimely death the life insurance policy will come to the rescue of their family, to some extent. Hence, insurance agents tend to talk about everything except untimely death.

Such behaviour stems from the fact that people react to things differently, depending on how they are framed. As Thomas Gilovich and Lee Ross write in The Wisest One in the Room—How You Can Benefit From Social Psychology’s Most Powerful Insights: “Psychologists over the past thirty years have demonstrated time and again that the tiniest change in how a question is worded or how an option is described can radically alter how it is understood—and therefore how people respond.”

So, if life insurance is sold as something you buy for the financial safety of your family in case of your untimely death, it doesn’t get sold. This happens because people don’t like being told about the most obvious truth in life.

Nevertheless, when they are told about returns and tax saving advantages, they queue up to buy the same insurance policy. In fact, another impact of this is that most insurance sold in India is not pure life insurance. Most insurance sold in India is essentially some form of investment with a dash of life insurance being built into it.

This leads to a situation, where people who buy insurance thinking it is insurance, are not adequately covered. In case of untimely death, the insurance payout along with the value of the investment, is unlikely to help the family maintain the same standard of living, as was in the past.

Such behaviour is visible not just when it comes to buying insurance but in other areas of life as well. As Gilovich and Ross write: “[People]…are more impressed by condoms whose manufacturers boast of a 95 per cent success rate rather than a 5 per cent failure rate. They are more supportive of taxes on the rich when the existing level of income inequality is described in terms of how much more the rich earn than the median wage earner than when it is described in terms of how much less the median wage earner earns than the rich.”

Hence, the way an option is framed leads to how people react to it. Let’s go into the issue of inequality a little more through the example of a factory. Let’s say the median salary of a worker working in this factory is Rs 5 lakh per year and that of a manager is Rs 25 lakh.

So the salary of a manager is 400 per cent more than that of a worker. But the salary of a worker is 80 per cent lower than that of a manager. Even though both options mean the same, the 400 per cent option sounds much worse than the 80 per cent option. And that is why Gilovich and Ross say what they do about taxes for the rich.

Another area where framing is put to good use are retail sales. Instead of having sales two or three times a year, retail chains can have lower prices all through the year. It would basically amount to the same thing. But lower prices all through the year, just doesn’t have the same emotional appeal of a discount, which gets people into the buying mode.

The point being that how an issue is framed essentially decides how it ends up in the mind of the consumer and how he or she reacts to it.

This column was originally published in Bangalore Mirror on August 31, 2016

11 April, 2016

The UnReal State of India’s Real Estate

Over the weekend a friend called and we talked about an interesting conversation he had had with his landlord.

My friend’s landlord is a successful corporate executive and doesn’t live in the same city as my friend does. The landlord had bought the flat that my friend currently lives in, sometime in late 2004.

At that point of time he had paid around Rs 18 lakhs for it. This is what my friend could gather from the conversation with his landlord. The flat is currently worth close to Rs 1.3 crore.

In a period of close to 12 years, the market value of the flat has gone up more than seven times. And this is where things get interesting.

My friend currently pays a rent of around Rs 27,000 per month or Rs 3.24 lakh per year for this flat. The rental yield works out to around 2.5%. Rental yield is obtained by dividing the annual rent by the current market price of the flat.

The question is why would someone want to continue owning an asset which generates a return of 2.5% per year. The interest rate offered on money kept in savings bank account is at least 4%.

So the point is when you can earn a minimum 4% fixed return with none of the headaches that come with owning real estate, why would you choose to earn 2.5%? Also, the actual rental yield is lower than 2.5%, given that a certain amount of maintenance has to be paid to the building society every month.

Then there is the cost of maintaining the flat. Further, property tax also needs to be paid every year. In this scenario it makes perfect sense to sell the flat and invest the money in bank fixed deposits, which currently pay around 7-8% per year.

I put this thought across to my friend and who in turn spoke to his landlord. And the answer he got was very interesting.

The landlord told my friend that his rental yield was 18%. It took me a while to understand how he came around to this number. He was calculating the rental yield on the original price that he had paid for the flat.

A rent of Rs 3.24 lakh on a purchase price of Rs 18 lakh works out to a yield of 18%. While, this is totally wrong, but this is the way my friend’s landlord is currently thinking. He thinks he is earning 18% from his flat and won’t sell.

But he can sell the flat, pay tax on the indexed capital gains and invest the remaining amount in a fixed deposit and earn much more than Rs 3.24 lakh he is currently earning. Over and above this, this investment comes with none of the headaches of owning real estate.

This is not exactly rocket science. It is simple mathematics. So what exactly is preventing my friend’s landlord from selling out? One answer could be tax deduction on the interest payment of the home loan that he had taken in order to buy the house.

But given that the loan is in its twelfth year of repayment, the interest component will be quite small in comparison to the landlord’s current income and really not worth the trouble.

So what gives? The landlord is totally anchored into the price appreciation that has happened till date. His investment has increased in value from Rs 18 lakh to Rs 1.3 crore in a period of over 11 years.

And this is something that is stuck in the landlord’s mind. Before I go any further, it is important that I explain the term anchoring here. As Garly Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes and How to Correct Them: “Anchoring is really just a metaphoric term to explain the tendency we all have of latching on to an idea or fact and using it as a reference point for future decisions. Anchoring can be particularly powerful because you often have no idea that such a phenomenon is affecting you.”

This applies in case of my friend’s landlord. He has seen the price of the appreciate from Rs 18 lakh to Rs 1.3 crore and has a strong belief that the appreciation will continue. In the process he has held on to this flat. He is anchored into that belief.

Is a similar sort of increase possible? It would mean that the price of the flat would be more than Rs 9 crore (Rs 1.3 crore x seven times) eleven years from now. That is totally unbelievable.

Also, the real estate prices haven’t gone anywhere over the last few years. Most people don’t take that into account. The money illusion is at work. As Belsky and Gilovich write: “This involves a confusion between “nominal” changes in money and “real” changes that reflect inflation.”

Real estate prices have remained flat across large parts of the country over the last few years. The average rate of inflation between 2012 and now has been around 7-8%. Once we factor this into account, the real estate prices have actually come down by a reasonable amount in real terms.

Again, this is something that my friend’s landlord in particular and most other real estate owners in general don’t seem to understand. It will take some time for these people to realise this. Plus, there is always the bit about owning something you can see and feel, which always works with owning real estate. This obviously does not apply to financial investments.

Further, with a huge amount of unsold inventory of real estate companies, as well as homes that have been built and bought as an investment, in the market, real estate is not going to match the returns that it gave between 2002 and 2012. Those days are long gone. Also, it has just become way too expensive.

Of course, people take years to come around to realising that they have been wrong for a long time. Mistakes are not easy to admit and this time will be no different. Until then, the stagnation in the real estate sector will continue.

The column originally appeared on Vivek Kaul’s Diary on April 11, 2016

17 June, 2015

Money lessons from Uber

When it comes to technology I am a slow adopter. I got an email account only after most of my friends already had one. I started using Facebook and Twitter after these two social media websites had already taken off big time. Further, its been less than a year since I got a smart phone and given that I have only recently started using the app-based Uber taxi service.

For those who have used Uber will know that the company primarily offers three levels of taxi service. Its most basic service is uberGO. This is followed by uberX in the mid-range and UberBLACK in the top-range.

Further, the company does not take cash payments. In order to use Uber, you first need to create a wallet account with Paytm, transfer money into it from a bank account and then link it to the Uber app on your smart phone. The cost of the travel is deducted against the money in the Paytm account.

After using the Uber service, you don’t pay paper money or cash to the company. As mentioned earlier, the payment is deducted directly from the Paytm account. Hence, in that sense the situation is similar to when you buy something using a credit card or debit card.

And this is where things get interesting. Research shows that when people use their credit/debit cards they are likely to end up spending more in comparison to when they use cash, simply because there is no pain of purchase, as is the case when using cash.

Gary Belsky and Thomas Gilovich explain this phenomenon beautifully in Why Smart People Make Big Money Mistakes and How to Correct Them: “Credit card dollars are cheapened because there is seemingly no loss at the moment at the purchase, at least on a visceral level. Think of it this way: If you have $100 cash in your pocket and you pay $50 for a toaster, you experience the purchase as cutting your pocket money in half. If you charge that toaster though, you don’t experience the same loss of buying power that your wallet of $50 brings.”

The same stands true about using a debit card as well or for that matter a wallet account like Paytm, to purchase things. “In fact, the money we charge on plastic is devalued because it seems as if we’re not actually spending anything when we use cards. Sort of like Monopoly money,” the authors add.

Hence, as people don’t feel the pain of spending money, they are likely to spend more. “You may be surprised to learn that…you not only increase your chances of spending to begin with, you also increase the likelihood that you will pay more when you spend than you would if you were paying cash,”Belky and Gilovich write.

So how is all this linked to Uber? The area that I live in central Mumbai, uberGo, which works out cheaper than even a kaali-peeli taxi and is air-conditioned, is not so easy to get. On days I don’t find an uberGo I end up using an uberX which is more expensive than a kaali-peeli. And on a couple of occasions I have also ended up using UberBLACK, which is significantly more expensive than a kaali-peeli taxi.

The reason for this is straight forward. Since I don’t have to pay Uber in cash, I don’t feel the pain of paying and end up using a service which is more expensive than a kaali-peeli. In fact, since I am paying using a smartphone the pain of payment is even lower than when using a credit or a debit card, given that payment through a smart phone using a wallet is one more step removed from cash than a credit or a debit card.

This also explains why almost every e-commerce site wants you to shop using an app and not from their website. Since you may pay using a smartphone through a mobile wallet account, there is chance that you will end up spending more money.

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The column originally appeared in the Bangalore Mirror on June 17, 2015

5 February, 2014

Retail discount ‘sales’: Why high prices and big discounts go hand in hand

Vivek Kaul
The sale season is currently on. If you are the kind who likes to frequent malls on weekends (or even weekdays for that matter) you might have realised by now that discounts are on offer, almost everywhere.
The question is why do retail stores do this? As Tim Harford writes in The Undercover Economist “We’re all so used to seeing a store-wide sale with hundreds of items reduced in price that we don’t pause and ask ourselves why on earth shops do this. When you think hard about it, it becomes quite a puzzling way of setting prices.”
And why is that? “The effect of a sale is to lower the average price a store charges. But why knock 30 percent off many of your prices twice a year, when you could knock 5 percent off year around? Varying prices is a lot of hassle for stores because they need to change their labels and their advertising, so why does it make sense for them to go to the trouble of mixing things up?,” asks Harford.
There are multiple reasons for the same. As Harford writes “One explanation is that sales are an effective form of self targeting. If some customers shop around for a good deal and some customers do not, it’s best for stores to have either high prices to prise cash from loyal(or lazy) customers, or kow prices to win business from the bargain-hunters. Middle-of-the-road prices are not good: not high enough to exploit loyal customers, not low enough to attract bargain-hunters.”
Also, if the firm were to offer a fixed discount (say 5%) all through the year, it wouldn’t be regarded as a discount by consumers at all. This would happen simply because consumers would not have anything to compare a regular discount of 5% with. A regular discount of 5% compared with a regular discount of 5%, essentially implies no discount at all.
For any bargain to look like a bargain what economists call the “anchoring effect” needs to come into play. As John Allen Paulos writes in A Mathematician Plays the Stock Market “Most of us suffer from a common psychological failing. We credit and easily become attached to any number we hear. This tendency is called “anchoring effect”.”
The normal price of any product is the “price” a consumer is anchored to. As Barry Schwartz writes in The Paradox of Choice: Why More is Less “The original ticket price becomes an anchor against which the sale price is compared.”
This comparison tells the bargain hunters that a bargain is available and encourages them to get their credit cards out. Interestingly, research shows that people end up spending much more when they use their credit cards than when they spend cash.
Gary Belsky and Thomas Gilovich point this out in Why Smart People Make Big Money Mistakes and How to Correct Them, “Credit card dollars are cheapened because there is seemingly no loss at the moment at the purchase, at least on a visceral level. Think of it this way: If you have $100 cash in your pocket and you pay $50 for a toaster, you experience the purchase as cutting your pocket money in half. If you charge that toaster though, you don’t experience the same loss of buying power that your wallet of $50 brings.”
“In fact, the money we charge on plastic is devalued because it seems as if we’re not actually spending anything when we use cards. Sort of like Monopoly money,” the authors add. Given this, when people do not feel the pain of spending money, they are likely to spend more. “You may be surprised to learn that by using credit cards, you not only increase your chances of spending to begin with, you also increase the likelihood that you will pay more when you spend than you would if you were paying cash,”Belky and Gilovich write.
This benefits the retailer offering the discount. What he loses out on by offering a discount on the product, he more than makes up for through an increase in volumes.
Of course, there are other reasons like trying to get rid of inventory, before a new season comes on. If the retailer has not been able to sell too many jackets during the winter season, he might try to offload it at a discount before the summer season comes on, instead of holding it back till the next winter season. High end designer stores face the risk of styles going out of fashion. Hence, they need to get rid of their inventory pretty quickly. But this doesn’t really hold for everyone (Think about this: how many of us wear clothes that are radically different in style when compared to last year?).
Hence, retailers essentially have sales to get the anchoring effect going, which, in turn, encourages people to get their credit cards out, and spend more money than they normally would. To conclude, here is a tip to avoid the crowds during the sale season. One day before the sale opens, go the store and check out what you want to buy. If you are buying clothes, figure out what you like and check out whether they fit. Visit the store again the next day, and simply pick up the clothes you liked (to the condition that they are on discount). This will ensure you may not have to spend time standing in a queue before the trial room, waiting for your turn.
The article originally appeared on www.firstbiz.com on February 5, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)

12 November, 2012

Gambler’s fallacy: The lesson I learnt last Diwali

Kyon daren zindagi main kya hoga, kuch na hoga to tajurba hoga’ – Javed Akhtar (tajubra = experience)
Experience is a great teacher, but the trouble is it only comes with time, and by then the mistakes have already been made.
Last Diwali I played teen patti for the first time with friends and family. I started cautiously with a hundred rupees bet. But with the beginners luck at work I easily won the next few rounds and half an hour later I had won Rs 5,000 and was now worth Rs 5,100 in total, which included the Rs 100 I had started with as well.
Then egged on by sister I bet the entire Rs 5,100 blind, on the tenth round that we were playing. And against the luck of the draw, I lost.
I turned around wanting to look at my sister, but before I could say anything i.e. call her names she said “Don’t worry bhaiyya you just lost a hundred rupees.”
Now did I? Was that really the case? Or was something else at work?
Following the time tested method of when in doubt then Google, I came to realise that I had just become a victim of what behavioural economists (a section of economists who link human psychology to economics) call “mental accounting”.
Richard Thaler, a pioneer in the field of Behavioural Economics and who coined the term mental accounting, defines it as “the inclination to categorise and treat money differently depending on where it comes from, where it is kept and how it is spent.”
This leads to what is referred to as the gambler’s fallacy, the tendency of gamblers who lose their winnings, feeling that they haven’t lost anything at all. Precisely, like what my sister said.
Thaler along with Cass Sunstein explains this in his book Nudge — Improving Decisions About Health, Wealth and Happiness. “You can also see mental accounting in action at the casino. Watch a gambler who is lucky enough to win some money early in the evening. You might see him take the money he has won and put it into one pocket and put the money he brought with him to gamble that evening (yet another mental account) into a different pocket,” write the authors.
The gamblers call their winnings ‘house money’. As the authors write “The money that has recently been won is called ‘house money’ because in the gambling parlance the casino is referred to as the house. Betting some of the money that you have just won is referred to as ‘gambling with the house’s money’; as if it was, somehow, different from some other kind of money. Experimental evidence reveals that people are more willing gamble with money that they consider house money.”
The house money effect is even seen at work when stock markets are on an upside. Thaler and Sunstein, give the example of the late 1990s when the world was seeing the dotcom bubble. “Mental accounting contributed to the large increase in stock prices in the 1990s, as many people took on more and more risk with the justification that they were playing only with their gains from the last few years,” they write.
It isn’t only while gambling and investing in stock markets that human beings categorise money in different ways. As John Allen Paulos writes in A Mathematician Plays the Stock Market “People who lose a $100 ticket on the way to a concert, for example, are less likely to buy a new one than are people who lose $100 in cash on their way to buy the ticket. Even though amounts are the same in the two scenarios, people in the former one tend to think $200 is too large an expenditure from their entertainment account and so don’t buy a new ticket, while people in the latter tend of assign $100 to their entertainment account and $100 to their “unfortunate loss” account and buy the ticket.”
Or sample this situation. Let’s say you are at an electronics shop looking to buy a laptop. You finally decide to buy a model which costs around Rs 36,300. Just as you are paying for it a friend calls and tells you about a better deal on a website which is offering the same model for Rs 36,000? Will stop the purchase and go back home and order the laptop from the website? The chances are no.
But consider another situation where you are out looking to buy a DVD player. You finally zero down on a model that costs Rs 3000. At that point of time a friend calls and tells you that the same thing is available on a website for Rs 2700. Will you stop the purchase and go back home and order the DVD player from the website? The answer is yes.
The funny thing is that in both the cases you would have saved Rs 300. But in one case you decided to go ahead with the transaction and in another case you did not? Why does this happen? At a fundamental level the Rs 300 we save is being categorised into different mental accounts because we are thinking in terms of percentages. Rs 300 expressed as a percentage of Rs 36,300 is very small whereas Rs 300 expressed as a percentage of Rs 3000 is significantly larger.
This tendency to categorise money into different mental accounts leads to several other interesting situations. Money that comes in rather unexpectedly, like a tax refund, a salary arrear, a higher than expected bonus at the end of the year, or a generous cash gift from a visiting relative for that matter, gets spent faster.
As Gary Belsky and Thomas Gilovich point out in their book Why Smart People Make Big Money Mistakes and How to Correct Them “Consider tax refunds, for example. Many people categorise such payments from the government as found money – and spend it accordingly – even though a refund is nothing more than a deferred payment of salary. Forced savings, if you will. If, on the other hand, those same people had taken that money out of their paycheck during the course of the previous year …they would most likely think long and hard before spending it on a new suit or Jacuzzi.”
This also leads to a situation where people have personal loans or huge credit card balances outstanding even though they have money lying in the bank earning nterest in the savings account or in the form of a fixed deposit. This despite the fact that the interest earned on a fixed deposit is much lower than the interest being paid on a personal loan or credit card balance outstanding.
In fact research has been carried out to show precisely this. “David Gross and Nick Souleles (2002) found that the typical household in the sample of Americans had more than $5,000 in liquid assets (typically in savings accounts earning less than 5% per year) and nearly $3,000 in credit card balances, carrying a typical interest rate of 18% or more,” write Thaler and Sunstein. Now wouldn’t it have been much simpler to pay off the credit card debt instead of paying such a high rate of interest on it?
But mental accounting is at work. People put the loan outstanding into the loan mental account whereas money in the bank gets categorised as a savings mental account. And the two do not meet. As the Thaler and Sunstein write, “Many of these households have borrowed up to the limits that their credit cards set. They may realise that if they paid off the credit card debt from the savings account, they would soon run up the cards to their limits once again. (And credit card companies, fully aware of this, are often more than willing to extend more credit to those who reached the limit, as long as they aren’t yet falling behind on interest payments.”
Hence it is important to remember that money is fungible. So there is no point in having money lying in a fixed deposit while you are still paying off your credit card balance or a personal loan for that matter. The interest you earn on your fixed deposit will be always lower than the interest you pay on your credit card debt or on a personal loan. Given this it makes more sense to first and foremost pay off your debts instead of saving money while categorising it into a “mental account”.
If all this wasn’t enough, have you ever wondered why shops and malls actually accept payments made through credit and debit cards, even though they do not get the full price on those transactions? Well the answer again comes back to mental accounting.
As Belsky and Gilovich point out, “In fact, credit cards…are almost by definition mental accounts, and dangerous ones at that. Credit card dollars are cheapened because there is seemingly no loss at the moment at the purchase, at least on a visceral level. Think of it this way: If you have $100 cash in your pocket and you pay $50 for a toaster, you experience the purchase as cutting your pocket money in half. If you charge that toaster though, you don’t experience the same loss of buying power that your wallet of $50 brings.”
Given this, while shopping most individuals end up paying more when they use their credit cards. And that explains why shops accept credit cards happily even though they get paid only around 98% of the price of what is purchased. But they benefit because the size of the purchase goes up.
If you still haven’t understood what mental accounting is all about here is a brilliant example that Thaler and Sunstein talk about. “The concept is beautifully illustrated by an exchange between Gene Hackman and Dustin Hoffman. Hackman and Hoffman were friends back in their starving artist days, and Hackman tells the story of visiting Hoffman’s apartment and having his host ask him for a loan. Hackman agreed to the loan, but then they went into Hoffman’s kitchen, where several mason jars were lined up on the counter each containing money. One jar was labelled ‘rent,’ another ‘utilities,’ and so forth. Hackman asked why, if Hoffman had so much money in jars, he could possibly need a loan, whereupon Hoffman pointed to the food jar, which was empty.”
The article originally appeared on www.firstpost.com on November 12, 2012.
Vivek Kaul is a writer. He can be reached at [email protected]