Lollapalooza from Insider Trading

Once upon a time, a friend of mine knew someone, who knew someone in a big, listed company. And through this chain, he got reliable, price sensitive, inside information about the company.

The information was this: In two weeks, there would be an announcement about the settlement of a major legal dispute in which the company was involved. The settlement was going to be hugely in favor of the company.

The sums involved were large and my friend estimated that when the news becomes public information, the stock should soar by a minimum of 150%. His computations were conservative.

And so, my friend concluded that this was a once in a lifetime opportunity to become richer than he already was. This was his chance to be free.

He decided to back up the truck. He quickly liquidated his entire stock portfolio, worth a substantial sum, and all his other assets, and used the entire proceeds to buy his favorite stock. And then, he borrowed more money and trebled his position in the stock.

And in a matter of two weeks, he went bust. And he went bust despite the inside information he was betting so heavily on, being correct.

What happened?

This is what happened: Just before the announcement my friend was betting on, a massive earthquake hit the only plant of the company and completely destroyed it and its associated future earning power. The stock fell 40% despite the announcement of the positive news. The market ignored the positive news my friend had bet everything on and focused on the new development instead.

The banks, who had lent money to my friend, asked him to put up more money or securities in his account. But he didn’t have any more money or securities. All of his wealth was in this one stock. And so, the bank liquidated his stock in a fire sale, and he lost every penny he had earned and saved. He went bankrupt. The irony, of course, is that he was right about the information, but he still went bust. Now, that’s a lollapalooza.

What created this lollapalooza outcome?

This is a very interesting question.

Lollapalooza outcomes do not happen for just one reason. There has to be a combination of several mental models, all working in the same direction, which produces lollapalooza outcomes.

Which mental models combined to produce this horrible outcome for my friend? There were four:

  1. Tendency to overweigh scarcity;
  2. Excessive self-regard tendency;
  3. Over-optimism; and
  4. Availability-misweighing tendency.

Of these four tendencies, the first one is described very well in Robert Cialdini’s great book, Influence. The other three tendencies were described by Mr. Charlie Munger in his essay titled “The Psychology of Human Misjudgment” included in his biography.

Under the scarcity principle, we tend to overvalue something that is scarce. The tendency that makes us rush and buy things we do not need in discount sales that will end in a few hours is the same tendency that makes us put a high value on useless information when it is put under censorship. The very same tendency makes investment opportunities available to us seem more valuable when they are not available to others.

My friend had access to privileged, and valuable, information. This automatically led him to over-weigh the value of the information in his possession.

In his essay, Mr. Munger talked about excessive self-regard tendency leading to what he called as the “endowment effect”. Man has an automatic tendency to over-weigh something in his possession. That includes himself, his family members and friends, and his material possessions. If you suffer from this tendency, then if you own something, you’ll value it more highly than you would have, if you did not own it. If asked to sell it, you’d tend to ask for a substantially higher price than its true worth. This tendency makes someone, who has bought a stock, even more bullish about it than before, immediately after he bought it.

My friend suffered from the endowment effect. Not only the information was valuable because it was scarce, the endowment effect made it even more valuable to him immediately after he possessed it. And that, of course, led to over-optimism which led him to bet everything he had (and more through borrowed money) on one stock.

There is one more tendency which contributed towards my friend’s gamble. This is the availability-misweighing tendency. To quote Mr. Munger:

“Man’s imperfect, limited-capacity brain easily drifts into working with what’s easily available to it. And the brain can’t use what it can’t remember or when it’s blocked from recognizing because it is heavily influenced by one or more psychological tendencies bearing strongly on it. . .”

In my poor friend’s situation, the tendency to overweigh scarcity and excessive self-regard tendency combined to produce over-optimism tendency, and the combined power of these three tendencies made him totally blind as to the possibility of some event that could make his excessive investment in the company, wrong.

The availability heuristic is the source of one of the most common biases we all suffer from– the availability bias. As Tversky and Kahneman explained in 1973, we assess the frequency, probability, or likely causes of an event by the degree to which instances or occurrences of that event are readily “available” in memory.

And, of course, if something is not available in our memory, we simply cannot assign a weight to it so we leave it out of our decision-making process, leading us to make bad judgment calls, like in my friend’s case.

My friend forgot to ask the simple question: “Despite my possession of this wonderful, and scarce, information, are there factors that could possibly make my decision a bad one?” He did not seek evidence that disconfirmed his much-loved notion. And that, in my view, destroyed him.

If he has asked this simple question, he would have come to the correct conclusion that Mr. Munger gave in his essay: “An idea or a fact is not worth more merely because it’s more available to you.”

So, that’s how these four psychological tendencies combined together and impaired the cognition of my friend, thereby ensuring that he lives miserably ever after. . .