1 Quirk In Our Brain That Can Make Investing Dangerous

Dan Ariely made a very interesting point in his book “Predictably Irrational” that we, humans, generally do not see things in absolute terms – we view most things on relative terms. You can read more about it in his bog post here.

Arriely, who’s a professor at Duke University on the subject of psychology and behavioural economics – and the author of multiple books on said topics – realized that many newspaper subscription models have the following option for buyers (prices are hypothetical):

  • Internet only – $80
  • Print only – $150
  • Print + Internet – $150

From the options, I trust it’s obvious to see that the print-only option is not really an option because no one would logically choose it.

But what Arriely realized is that the presence of the second option alone would cause readers to feel that the third option – the one with both print and internet subscriptions – is a good deal, thus leading to more picking the third option.

His realisation came when he found out that if the second option is removed, most readers would opt for the cheaper option 1.

It is important to note that this is just the way our brains function and any logical soul would come to the same conclusions on the three subscription options.

Wait a minute. Why am I talking about newspaper subscriptions here? Well, that’s because the phenomenon of seeing things in relative terms might be an issue when it comes to investors valuing a company – and it can be dangerous.

When it’s wrong to compare

For instance, let’s say we’re thinking of investing in the telecommunications industry. In Singapore, we have the trio of  Singapore Telecommunication Limited (SGX: Z74), Starhub Ltd. (SGX: CC3), and M1 Ltd (SGX: B2F) to pick and choose from.

At the moment, Singtel’s shares carry a trailing price-to-earnings (P/E) ratio of 17.5 while both Starhub and M1 have PE ratios of a smidge below 20. With this information, we might jump to the conclusion that Singtel is cheap and therefore it’d be worthy of our investment dollars.

However, by doing so, we are ignoring the fact that the trio are very different companies despite them all belonging to the telecommunications industry. The difference in their P/E ratios might be due to differences in many factors such as their accounting standards, their business prospects, or their management’s abilities.

Furthermore, although Singtel might look cheaper compared to the other two telcos, we would also have to consider the whole industry’s valuation as well – it’s no use being the best block in the worst neighbourhood around town. For some perspective, Singapore’s broader market, as represented by the Straits Times Index (SGX: ^STI) is only trading at a P/E ratio of around 13.

When we think about such issues, SingTel might even be overvalued even if it looks cheaper than its peers.

Foolish Summary

Valuation is never a straight forward subject – but that is what makes it so interesting.

We have to not only know how to work the numbers for different types of valuation methods, but we should also have a good grasp of how our brain functions so that we can set-up barriers to protect ourselves from biases that we cannot control.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.