How the denomination effect messes up your decisions?

Large numbers tend to scare us, we can’t process them mentally. We are more comfortable with smaller ones. This in essence is the denomination effect.

Of the several cognitive biases that affect us as individuals, Denomination Effect is an important one. It comes in our way everywhere – buying a phone, property or even mutual funds and stocks.

Let me ask you – What’s bigger – a Rs 500 note or 10 notes of Rs. 50 each? 

“Stupid”, you might think.

Well, not so much. Let me put it another way. 

An upfront payment of Rs. 60k for the smartphone or an EMI of Rs. Rs. 2500 per month for 2 years. 

As per current practice, several people are expected to pick the second one.

Same is true for real estate. Rs. 75 lakh apartment might be expensive but a Rs 55,000 EMI suddenly makes you feel “hopeful”.   

Our mind feels just fine agreeing to and processing the smaller numbers. The cognitive bias that tricks you is the “Denomination Effect.”

Rs. 60k for a phone sounds expensive, but Rs. 2500 per month payment is completely workable. 

So, on the one side it influences how you spend and which things you buy, it can also influence your savings and investments.

When you plan your goals and investments, the numbers matter a lot. If I tell that you need Rs. 2 crores for your retirement, you are going to be taken aback, frozen. 

Wait! What if just a Rs. 5000 per month of investment through EPF + Equity Mutual Fund Systematic Investment Plan will do the trick? 

This feels like a relief.  

Talking of SIPs and mutual funds, the denomination bias works negatively too. 

The Case of High mutual fund NAV

I have found so many investors complain about the high Net asset Value or NAV of a mutual fund scheme. 

So a fund with an NAV or the price at which you buy or sell per unit, of Rs. 600 looks high. They think it is expensive and will have very little room to grow.

Fortunately, it doesn’t work that way. A mutual fund scheme’s NAV is only a reflection of the value of underlying investments.

Today, at Rs. 600 NAV, I could sell all of my holdings in the fund and convert to cash and yet the valued remains at Rs. 600 / unit. The only difference is that the underlying holding is cash and not stocks/bonds. 

I can then buy stocks or bonds again for the same money, afresh and still have the same Rs. 600 NAV.

Investors may sometimes take time to understand this. But in the meanwhile, they tend to make mistakes. Such as to for those Rs. 10 NFO. At least, the concept used to sell a lot in the past.

A lower NAV is perceived to be of a lower denomination, more affordable, cheap, etc. It’s just the wrong perception.  A standalone NAV is not at all relevant in selecting your mutual fund scheme.

Let’s take some examples. 

Here are some of the names of a few mutual fund schemes that have existed for over 15 years and their current NAVs (as on May 10, 2019). Only direct plans considered. 

Do you consider these funds “expensive” or “over valued”? 

Actually, the higher the NAV reflects a bigger experience of money management over market cycles and hence makes the scheme more valuable, may be even more reliable. 

Does the denomination effect work in direct stocks too?  

Same story.

So many investors filter for stocks priced under Rs. 100 or under Rs. 50, even penny stocks. The cheap ‘denomination’ stocks are mistaken to be value buys. Nothing can be further from reality.

In my own shortlist of about 40 companies for buying direct stocks, only 6 companies have a current market price of less than Rs. 100.

Here are some of the high price companies with the current market price / share.

Source: screener.in; Prices as on end of day May 10, 2019. 

I hope you agree that the price itself says nothing about the valuation or quality.  

Biggest surprises may sometimes come in small packages. That may not be true everywhere. Don’t fall for the denomination effect.

Does this bias affect you at times? How do you manage? Do share your thoughts in the comments section.