Relativity bias: this is better because that is worse

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Apart from good strategy and good execution, successful investors are also good at avoiding certain behavioral biases or preferences that keep you away from investment success. Remember, there is a major issue of behavioral biases in investing. That is because our grooming conditions us to think and act in a particular manner and over time it becomes a habit or part of your investment behaviour.

Relativity bias is when investors focus on a single aspect of buying stock to the exclusion of all other considerations. For many consumers, price is the most important part of the decision-making process, often understandably so.

People experiencing Relativity bias often:

  1. Ignore the potential benefits of stock in favor of focusing solely on price
  2. Actively seek out other incentives
  3. Respond well to flexible pricing structures

The relativity trap is a common pitfall in investing, too. Certain valuation multiples may make a company look like a bargain compared to its peer group. In reality, this just might be an illusion—the companies may be vastly different, their price compared to a historical precedent may not account for changes in the marketplace or the multiple may fail to factor in something important, such as the precarious state of its balance sheet. In investment circles, these relativity traps are known as "value traps."

Relative bias can cause a financial market participant, such as a financial analyst or investor, to make an incorrect financial decision, such as buying an undervalued investment or selling an overvalued investment. Relative bias can be present anywhere in the financial decision-making process, from key forecast inputs, such as sales volumes and commodity prices, to final output like cash flow and security prices.

Historical‌ ‌values,‌ ‌such‌ ‌as‌ ‌acquisition‌ ‌prices‌ ‌or‌ ‌high-water‌ ‌marks,‌ ‌are‌ ‌common‌ ‌Relative‌ ‌Bias.‌ ‌This‌ ‌holds‌ ‌for‌ ‌values‌ ‌necessary‌ ‌to‌ ‌accomplish‌ ‌a‌ ‌certain‌ ‌objective,‌ ‌such‌ ‌as‌ ‌achieving‌ ‌a‌ ‌target‌ ‌return‌ ‌or‌ ‌generating‌ ‌a‌ ‌particular‌ ‌amount‌ ‌of‌ ‌net‌ ‌proceeds.‌ ‌These‌ ‌values‌ ‌are‌ ‌unrelated‌ ‌to‌ ‌market‌ ‌pricing‌ ‌and‌ ‌cause‌ ‌market‌ ‌participants‌ ‌to‌ ‌reject‌ ‌rational‌ ‌decisions.‌ ‌

Relative bias ‌can‌ ‌be‌ ‌present‌ ‌with‌ ‌relative‌ ‌metrics,‌ ‌such‌ ‌as‌ ‌valuation‌ ‌multiples.‌ ‌Market‌ ‌participants‌ ‌using‌ ‌a‌ ‌rule-of-thumb‌ ‌valuation‌ ‌multiple‌ ‌to‌ ‌evaluate‌ ‌securities‌ ‌prices‌ ‌demonstrate‌ ‌relative bias when‌ ‌they‌ ‌ignore‌ ‌evidence‌ ‌that‌ ‌one‌ ‌security‌ ‌has‌ ‌a‌ ‌greater‌ ‌potential‌ ‌for‌ ‌earnings‌ ‌growth.‌ ‌

Some‌ biases,‌ ‌such‌ ‌as‌ ‌absolute‌ ‌historical‌ ‌values‌ ‌and‌ ‌values‌ ‌necessary‌ ‌to‌ ‌accomplish‌ ‌an‌ ‌objective,‌ ‌can‌ ‌be‌ ‌harmful‌ ‌to‌ ‌investment‌ ‌objectives,‌ ‌and‌ ‌many‌ ‌analysts‌ ‌encourage‌ ‌investors‌ ‌to‌ ‌reject‌ ‌these‌ ‌types‌ ‌of‌ ‌anchors.‌ ‌Other‌ ‌anchors‌ ‌can‌ ‌be‌ ‌helpful‌ ‌as‌ ‌market‌ ‌participants‌ ‌deal‌ ‌with‌ ‌the‌ complexity‌ ‌and‌ ‌uncertainity ‌inherent‌ ‌in‌ ‌an‌ ‌environment‌ ‌of‌ ‌information‌ ‌overload.‌ ‌Market‌ ‌participants‌ ‌can‌ ‌counter‌ relativity ‌bias‌ ‌by‌ ‌identifying‌ ‌the‌ ‌factors‌ ‌behind‌ ‌the‌ ‌anchor‌ ‌and‌ ‌replacing‌ ‌suppositions‌ ‌with‌ ‌quantifiable‌ ‌data.‌ ‌

Comprehensive‌ ‌research‌ ‌and‌ ‌assessment‌ ‌of‌ ‌factors‌ ‌affecting‌ ‌markets‌ ‌or‌ ‌a‌ ‌security's‌ ‌price‌ are ‌necessary‌ ‌to‌ ‌eliminate‌ relativity ‌bias‌ ‌from‌ ‌decision-making‌ ‌in‌ ‌the‌ ‌investment‌ ‌process.‌ ‌

The‌ ‌human‌ ‌brain‌ ‌works‌ ‌in‌ ‌a‌ ‌relative‌ ‌way‌ ‌when‌ ‌making‌ ‌comparisons‌ ‌and‌ ‌finds‌ ‌it‌ ‌difficult‌ ‌to‌ ‌compare‌ ‌across‌ ‌different‌ ‌categories.‌ ‌Savvy‌ ‌marketers‌ ‌frequently‌ ‌seek‌ ‌to‌ ‌exploit‌ ‌this,‌ ‌coaxing‌ ‌consumers‌ ‌into‌ ‌pursuing‌ ‌a‌ ‌spending‌ ‌decision‌ ‌that‌ ‌maximizes‌ ‌their‌ ‌profit.‌ ‌

A‌ ‌restaurant‌ ‌offers‌ ‌a‌ ‌value‌ ‌sandwich‌ ‌for‌ ‌INR‌ ‌40,‌ ‌a‌ ‌regular‌ ‌sandwich‌ ‌for‌ ‌INR‌ ‌80,‌ ‌and‌ ‌a‌ ‌premium‌ ‌burger‌ ‌for‌ ‌INR‌ ‌150.‌ ‌The‌ ‌relativity‌ ‌trap‌ ‌will‌ ‌ensure‌ ‌that‌ ‌most‌ ‌people‌ ‌opt‌ ‌for‌ ‌the‌ ‌regular‌ ‌burger,‌ ‌perceiving‌ ‌it‌ ‌to‌ ‌be‌ ‌the‌ ‌best‌ ‌value.‌ ‌

The‌ ‌consumer‌ ‌may‌ ‌assume‌ ‌that‌ ‌the‌ ‌value‌ ‌sandwich‌ ‌is‌ ‌inferior‌ ‌because‌ ‌of‌ ‌its‌ ‌low‌ ‌price‌ ‌and‌ ‌that‌ ‌the‌ ‌premium‌ ‌sandwich‌ ‌is‌ ‌not‌ ‌worth‌ ‌its‌ ‌elevated‌ ‌price‌ ‌because‌ ‌of‌ ‌how‌ ‌it‌ ‌compares‌ ‌to‌ ‌the‌ ‌other‌ ‌offerings.‌ ‌However,‌ ‌if‌ ‌the‌ ‌price‌ ‌of‌ ‌the‌ ‌premium‌ ‌sandwich‌ ‌is‌ ‌slashed‌ ‌to‌ ‌INR‌ ‌90,‌ ‌a‌ ‌substantial‌ ‌number‌ ‌of‌ ‌people‌ ‌will‌ ‌choose‌ ‌it‌ ‌on‌ ‌the‌ ‌grounds‌ ‌that‌ ‌it‌ ‌is‌ ‌worth‌ ‌paying‌ ‌an‌ ‌extra‌ ‌INR‌ ‌50‌ ‌for‌ ‌a‌ ‌premium‌ ‌burger.‌ ‌This‌ ‌is‌ ‌the‌ ‌relativity‌ ‌trap‌ ‌at‌ ‌work‌ ‌again.‌ ‌

Another‌ ‌example‌ ‌of‌ ‌the‌ ‌relativity‌ ‌trap‌ ‌is‌ ‌the‌ ‌pricing‌ ‌models‌ ‌adopted‌ ‌by‌ ‌most‌ ‌clothing‌ ‌stores.‌ ‌If‌ ‌the‌ ‌regular‌ ‌price‌ ‌of‌ ‌a‌ ‌pair‌ ‌of‌ ‌jeans‌ ‌is‌ ‌INR‌ ‌999,‌ ‌the‌ ‌store‌ ‌will‌ ‌show‌ ‌the‌ ‌price‌ ‌as‌ ‌INR‌ ‌1999‌ ‌but‌ ‌subsequently‌ ‌discount‌ ‌them‌ ‌by‌ ‌50%‌ ‌so‌ ‌that‌ ‌the‌ ‌"sale"‌ ‌price‌ ‌is‌ ‌now‌ ‌INR‌ ‌999.‌

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Historical values, such as acquisition prices or high-water marks, are common Relative Bias. This holds for values necessary to accomplish a certain objective, such as achieving a target return or generating a particular amount of net proceeds. These values are unrelated to market pricing and cause market participants to reject rational decisions.

Relativing can be present with relative metrics, such as valuation multiples. Market participants using a rule-of-thumb valuation multiple to evaluate securities prices demonstrate Relativing when they ignore evidence that one security has a greater potential for earnings growth.

Some Relative Bias, such as absolute historical values and values necessary to accomplish an objective, can be harmful to investment objectives, and many analysts encourage investors to reject these types of Relative Bias. 

Other Relative Bias can be helpful as market participants deal with the complexity and uncertainty inherent in an environment of information overload. Market participants can counter Relativing bias by identifying the factors behind the anchor and replacing suppositions with quantifiable data.

Comprehensive research and assessment of factors affecting markets or a security's price is necessary to eliminate Relativing bias from decision-making in the investment process.

The human brain works in a relative way when making comparisons and finds it difficult to compare across different categories. Savvy marketers frequently seek to exploit this, coaxing consumers into pursuing a spending decision that maximizes their profit.

For example:

A restaurant offers a value sandwich for INR 40, a regular sandwich for INR 80, and a premium burger for INR 150. The relativity trap will ensure that most people opt for the regular burger, perceiving it to be the best value.

The consumer may assume that the value sandwich is inferior because of its low price and that the premium sandwich is not worth its elevated price because of how it compares to the other offerings. However, if the price of the premium sandwich is slashed to INR 90, a substantial number of people will choose it on the grounds that it is worth paying an extra INR 50 for a premium burger. This is the relativity trap at work again.

For example: Another example of the relativity trap is the pricing models adopted by most clothing stores. 

If the regular price of a pair of jeans is INR 999, the store will show the price as INR 1999 but subsequently discount them by 50% so that the "sale" price is now INR 999. 

Wrapping up

Now that you know the meaning of Relative bias, but everything has changed! it’s only logical that we move on to the next big topic - Frog in boiling water: nothing's changing! To discover more, head to the next chapter. 

A quick recap

  1. Relativity bias is when investors focus on a single aspect of buying a stock to the exclusion of all other considerations.
  2. Comprehensive research and assessment of factors affecting markets or a security's price is necessary to eliminate Relativing bias from decision-making in the investment process.
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