The fallacy of Numbers!
What do you make out of these scenarios? 1st scenario is about a home loan with an interest rate of 8% p.a. , 2nd is about a credit card loan you have taken and finally, the 3rd scenario is about a fixed deposit.
Here is an example to simplify the thought process.
You will be surprised to know the hidden meaning in each of these cases. In the first case, an 8% annual rate simply means that they charge you 8% but compounded every month which brings the effective rate of interest to 8.33% on your loan.
In the second case, when you take a credit card loan, they will simply mention it as 3% per month which in itself made to look like a lot less. But in effect, it is 36% per year and is compounded monthly to yield an effective interest rate of 42.95% on your loan!
And when banks run promotional ads on Fixed deposits, they mention an effective rate as 10.47% for example, which translates to a 10% nominal rate. Funnily they publish the correct rate when they have to sell you FDs so that it looks very attractive :)
In finance parlance, this kind of bias is called Loss aversion. People often feel the pain of loss more than the joy of gains. Researchers Ori and Rom Brafman, in their 2008 book, “Sway: The Irresistible Pull of Irrational Behavior,” write that athletic teams often play to avoid losing, rather than to win. Sharp-eyed opponents can exploit this timidity with more aggressive play. Source: U.S.News
Banks make you feel like you are not losing much and trap you to believe that you are earning more.
Let’s look at more examples. I am sure many of you would relate to this experience. Suppose you are searching for a rental home and an agent comes along with a list of choices. Surprisingly, he will first show you a couple of run-down homes which is good for nothing and would fall short of what you are looking for. Probably the 3rd or 4th one is a splash and it fits all your requirements but has a higher rental amount! The rental amount is such that it is designed to be about 20% to 30% higher but still within your reach. You would not want to let go of this opportunity and would immediately agree to settle for the house!
As Barry Schwartz writes in The Paradox of Choice, Why more is less — If a person comes out of the sauna and jumps straight to the pool, water seems to be colder. Whereas jumping into the same pool after some sub-zero indoor winter games, makes the water more warmth in feeling. Our mind works similar to our body. We suffer from recency bias ( remembering run down home) which we apply to compare(3rd home seemed attractive ) and contrast what we just see. Adding to that, the rental yield is just been made to look like you can take it with a bit of stretch.
The run-down homes were “Setup Properties” which were never meant to be sold!
And more of such fallacies happening in the world.
These are just a few basic examples but there are many such instances which are followed by banks/real estate agents/insurance guys. However the fallacy of numbers and how it impacts our decision is too vast to be put in a blog. This was my attempt to make us all aware of the fact that there is no free lunch but as consumers, we need to be aware of our biases and be conscious of the number games you are tricked into! What we see is not always what we infer and what we infer is not what we always get!
As Charlie Munger once said,
And even more so in the world of Finance.