Continuing the series on common cognitive biases that impact investors. In case you missed it, read the introduction and first in the series: neglect of probability here
What is scarce is valuable – Scarcity Error
In a research project in 1975, Prof. Stephen Worchel split participants into two groups. The first group received an entire box of cookies and the second group just two to taste. Both groups were then asked to rate the quality of the cookies. This was repeated several times. The 2nd group rated the quality of the cookies much higher than the other.
Gallery owners place a red dot under a large number of their paintings. The dots signify they’ve been sold so that a smaller number of paintings appear unsold.
To eat at the Noma restaurant in Copenhagen, you need to reserve a table. Reservations are only open on the 7th of any month, where within a limited window, you can book a table for up to three months in advance.
Look around and you’ll identify the signs of the scarcity error or scarcity bias in action. Shopping online is to be bombarded with indications of scarcity. The image below is an example, a regular page for a very unexciting product (no offence to those who make it).
Unless you’re naturally passionate about implements to keep your kitchen counter squeaky clean, you’re unlikely to leap into action to buy one. The designers of pages like these know this and so ensure you’re informed how scarce such “opportunities” are.
Scarcity Error: Rara sunt cara is a Roman saying meaning “Rare is valuable”. The value we assign to things goes up sharply when informed they’re scarce
How this bias sabotages investors
This happens in two ways.
Investing tools and knowhow: We have all been offered “early bird” discounts for registering in value investing courses with few seats remaining. Limited-time only offers to sign up for research or advisory services at massive discounts to the sticker price.
Check out this email I received from a popular advisory service. The highlighting is part of the original email.
I receive an email from them every couple of days with an offer that’s ending in the next few hours.
Making buying decisions: Financial media is designed to trigger investor activity. From the bright red and green tickers to the flashing graphics surrounding experts making predictions, it’s meant to convey the message “if you’re not buying and selling stocks right now, you’re falling behind”.
Every time a stock rises by sharply, it is investors experiencing scarcity error about the availability of good investments, forgetting the simple maxim that returns are decided by the price paid. It is scarcity error that caused the Reliance Power IPO (the then largest offering in Indian stock markets) to be subscribed 10 times by the end of the first day, and 70 times by the 3rd day. Scarcity error is also a primary reason why IPOs are poor investments.
Dealing with this bias
A thumb rule I operate with is, if something is being sold with a lot of “time is running out!” pressure, it’s probably because the value it offers is not sufficient when considered with a composed mind. Walk away.
Unlike your favourite brand of breakfast cereal, you don’t “need to own” any particular stock.
Remember that good companies do not necessarily mean good stocks.This means no company is a good investment irrespective of price.
So, that fantastic brand that’s growing top and bottomline at 30%+ and all that with minimal capital investment, is not a good investment if 15 years of super-normal growth is already priced into the stock. Move on.
Make your buying decisions outside market hours when there are no minute by minute price moves to nudge you. And if you must watch financial tv channels, please, put them on mute.
The world’s hardest restaurants to get a reservation link
What bad design can teach us about investor behaviour link
IPO: Imaginary Profits Only? link
Five biggest Indian IPOs ever link