In this week’s newsletter, we talk about Daniel Kahneman’s Prospect Theory, the controversy over the delisting of ICICI Securities, an exciting challenge for you and a lot more.
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Daniel Kahneman’s Prospect Theory
Daniel Kahneman passed away on 27th March and your LinkedIn feed is probably filled with people telling you why Kahneman’s book “Thinking, Fast and Slow” is the best book ever written.
And there’s no denying it’s a great book. But it also draws heavily from the research he conducted in the preceding decades. Research that won Daniel Kahneman, a psychologist with no formal training in economics, the Nobel Prize in Economics in 2002. So, we thought we’d talk about what led to him winning the prestigious award.
If you’ve ever taken an economics class, you’ll know the number one assumption embedded into most classic theories or models is that human beings are rational!
This assumption says that we will make sensible choices in our own self-interest. There’s even a term for this — “homo economicus”.
But Kahneman didn’t believe in this theory of rationality. He was a trained psychologist who knew that human beings are complex creatures with their own kinks. So when he came across an economics paper in 1970 that stated something so absurd, he knew he had to do something. He called up his friend Amos Tversky, a fellow psychologist in Israel, and they got to work to debunk some theories.
First things first, they addressed decision-making or rationality in a paper in 1971.
They said that human beings probably operated using two systems — one based on intuition and the other for reasoning.
Sidebar: Even though Kahneman’s book popularised this as System 1 and System 2, he credits it to a couple of other researchers Keith Stanovich and Richard West who originally came up with that labelling.
And the thing was that human beings liked to avoid cognitive efforts as much as possible. That we didn’t like mulling over things too much. That we preferred to use shortcuts or rules of thumb that would save time and mental bandwidth. So System 1 which relied on intuition often took over.
For instance, let me ask you a question.
“A bat and a ball cost ₹110 in total. The bat costs ₹100 more than the ball. How much does the ball cost?”
If your immediate answer was “₹10”, you’re wrong. But you chose that answer because ₹110 splits naturally into ₹100 and ₹10. So it seems right.
But if you’d thought about it for a few seconds, you’d have realized the ball is just ₹5. And since the bat is ₹100 more than the ball, the bat actually costs ₹105.
You let System 1 take over and didn’t slow down enough to let System 2 run through its deliberations. And most people end up in the same boat. We tend to trust a judgment that quickly comes to mind. And that could also lead to making wrong economic decisions that wouldn’t work in our favour.
It could have to do with a whole variety of things — it could depend on how a question is framed or even how recently information about something relevant has been made available to us.
But it all boils down the fact that rationality isn’t our strong suit.
So once they’d proven that human beings weren’t rational, the next question was how do people make decisions when there’s risk involved?
For instance, let’s say that I ask you to flip a coin. I tell you that depending on the outcome, you win ₹750, or you lose ₹500.
Would you take the risk?
Now back in the day, economic models followed something called the expected value theory. This says that since people are rational, they’ll calculate the probability of winning or losing. And since this is a coin flip, that’s a 50:50 shot. Then you’ll think that since you could potentially win more than you lose, it’s worth a try. So you’ll take the risk and flip it.
But in the 1700s, Swiss mathematician Daniel Bernoulli tutted his head and said this wasn’t true. And that even if the expected value suggested that you flip it, many people wouldn’t. And that’s because it all depends on the ‘utility’ that people ascribe to the wealth.
Basically, your decision to flip it will depend on how useful you think the wealth of ₹750 is going to be. Or how much you will benefit from it.
This was the expected utility theory. And for 300 years, this was the model most economists followed too. It was based on rationality too.
Until Kahneman and Tversky came along and said, “Hold on…we believe that’s incorrect. We think these sorts of decisions actually depend on an initial reference point. And it’s not just based on the final utility.”
So they explained this with an example (and you might have to read this bit twice).
Problem 1: You have ₹x in your bank account. But we give you an additional ₹1000. And then ask you to choose between these options — You have a 50% chance to win ₹1000 or get ₹500 for sure.
What would you choose?
You’ll probably take the sure thing. Right?
Problem 2: You have ₹x in your bank account. But we give you an additional ₹2000. And then ask you to choose between these options. You have a 50% chance to win ₹1000 or lose ₹500 for sure.
In this case, you’ll probably take the gamble.
But if you think about it clearly, in terms of the final state of wealth, both A and B are same. Both offer the certainty of being richer by ₹1500.
So as per the expected utility of wealth, you should’ve made the same choice in both cases.
But the reference point made a big difference in decision making. The reference point is higher than your current wealth by ₹1000 in Problem 1 and by ₹2000 in Problem 2.
And that means you end up thinking of the possible gain while evaluating Problem 1 and the possible loss while making a decision in Problem 2.
And it wasn’t just that.
Let’s take that initial coin flip example. When Kahneman and Tversky ran their experiments, they found that in a game of 50:50 probabilities, people would reject the game unless the possible win was at least twice the size of the possible loss.
And this led them to conclude that people were naturally risk-averse but the pain from a loss was also 2x the joy from a gain.
The results of this became the prospect theory in 1979and changed the face of economics.
Anyway, there’s just one last thing. Just because he won the Nobel Prize in Economics, didn’t mean that Daniel Kahneman was never wrong.
The bestseller, “Thinking, Fast and Slow”? Well, that was riddled with errors. Okay, it wasn’t completely his fault but more the fault of the studies he’d relied on for the book.
For instance, Kahneman used a field of psychology called social priming in his book while trying to explain concepts.
For the uninitiated, social priming simply means that if you present a subtle cue or stimuli, it can influence people’s behaviour at a later stage. And one of the biggest ‘fake’ stories to explain this theory is when a theatre showed the words “eat popcorn” and “drink Coca-Cola” for a few seconds on screen, everyone rushed to buy them without really knowing why they suddenly had the craving and the sales shot up.
But later research showed that social priming was a load of baloney. Researchers couldn’t replicate the results. And it simply didn’t work.
So yeah, Kahneman got a few things wrong in his time.
But here’s what we should know. He never let his mistakes deter him. He accepted them. And in fact, he was actually pretty proud of the mistakes. He believes there was pleasure in finding out that he was wrong because it then meant he would learn something new.
That’s the LinkedIn-esque takeaway everyone needs, no?
Until then…RIP Daniel Kahneman.
PS: While Kahneman won the Nobel Prize in Economics in 2002, Tversky died in 1996 and since Nobel Prizes are not awarded posthumously, he didn’t get a chance to share the honour.
Goodbye, ICICI Securities…
ICICI Securities will soon cease to exist on the stock market!
No, we don’t mean the company is winding up. But this week, ICICI Bank finally got the shareholders’ go-ahead to delist ICICI Securities from the stock market. It’ll continue to run as a subsidiary of the bank but shareholders like you and me can’t own its shares anymore.
But wait…this delisting event wasn’t without its fair share of drama.
See, there’s something you know about the typical delisting process in India.
Initially, the buyer initiating who’s initiating the delisting does a valuation and sets a floor price. This is based on the price the stock traded during 26 weeks before the delisting. Think of it as the bare minimum price that the buyer will pay.
And then begins the reverse book-building process. This helps to discover what price shareholders actually expect the buyer to pay. And it can be way higher than the floor price. The shareholders are given a certain window of time. They can offer their shares and say, “I’ll give you my shares if you pay me ₹xx.”
And for the delisting to be a success, the buyer needs to snag a total of 90% of the shares (including their own). And pay the exiting shareholders in cash.
But there’s a flipside to this. Reverse book building can create too much price uncertainty. Investors can quote whatever price tickles their fancy. And it can be quite unrealistic in some cases. For instance, Bloomberg looked at delisting deals worth over $100 million in India in the 7 years preceding 2022. And they found that most deals happened at a premium of 45–67%.
That’s actually double the premium that buyers in other parts of the world had to pay!
This is why companies are always wary when it comes to delisting. They fear they’ll have to pay through the nose if they want to go through with it
But in this case, ICICI Bank faced none of that trouble. The bank simply decided the valuation by itself. And told investors to say yes or no. There was no reverse book building.
Huh? Why was that the case, you ask?
Well, that’s thanks to a tweak in the rules by the Securities and Exchange Board of India (SEBI) in 2021.
The regulator said, “Look, we know that the current delisting situation could be cumbersome at times. So we’ll make an exception. If you want to delist your subsidiary, you don’t have to go through the reverse book-building process. Rather, you first need to prove that the parent company and the subsidiary are engaged in the same line of business. And if that’s okay, you can swap the shares. Give the shareholders in the subsidiary some shares of the parent. And you can determine a valuation based on the average price over the previous 60 days. All you need to do after that is get at least 70% of your minority shareholders to agree.”
Now you could argue that ICICI Bank and ICICI Securities aren’t strictly in the same line of business. But it appears that SEBI gave them an exemption for this.
And that paved the way for ICICI Bank. Last year, it decided it would be the first company to attempt such a delisting endeavour under these rules. And it announced that for every 100 shares someone held in ICICI Securities, they would get 67 shares of ICICI Bank instead. It would be a share swap and not a cash transfer.
And the displeasure was immediate.
As soon as the delisting event was announced in July 2023, an anonymous minority shareholder penned a letter to the board members of ICICI Securities. They pointed out something quite pertinent.
When ICICI Bank listed ICICI Securities in 2018, they asked for a valuation of 30 times the company’s earnings.
Since then, sales and profits have almost doubled. And earnings have grown by 15% annually.
And now that ICICI Bank wants to buy back the company, it is only willing to pay 18 times the earnings.
So, why is the proposed exit multiple lower than the entry multiple at the time of IPO, considering the overall business quality has significantly improved? How was this fair?
Minority shareholders felt they were being short-changed. That they were being taken for a ride by not being consulted on the price.
And the folks at The Ken highlighted another argument that shareholders were making.
Between 2018 and June 2023 (when the delisting announcement was made), ICICI Bank’s shares had risen by 200%. But ICICI Securities’ shares were higher by only 30%. And since the folks in charge of valuing the delisting had assigned a 40% weight to the market price, it meant that ICICI Securities’ shareholders weren’t being undervalued even though the business was doing well.
ICICI Securities’ shareholders believed that the stock would catch up soon enough and reward them for their patience. But by delisting the shares, they would lose out.
With all this angst, you could bet that the delisting would be under threat. ICICI Bank still needed 70% of these minority shareholders to vote in favour of the deal. But it didn’t seem likely that it would be able to sway their minds.
And when the e-voting for delisting finally began last week, the drama intensified.
Retail shareholders of ICICI Securities began to complain that executives from ICICI Bank had called them and messaged them to convince them to support the delisting process. They shared screenshots of these conversations too.
And that definitely wasn’t a good look for ICICI Bank. Everyone thought the delisting would be unsuccessful.
But when the final votes were tallied up, lo and behold, it was a miracle.
Even though nearly 67% of individual, retail investors (folks like you and me) voted against the resolution, the big institutional investors saved the day. And by big institutional investors, we mean folks such as Norway’s Norges Bank Investment Management. An overwhelming 84% of them voted in favour of the delisting.
And with that, despite all the brouhaha, ICICI Bank has managed to climb over the line. It got 72% of the votes in favour of the delisting and that means, we’ll have to soon bid a stock market goodbye to ICICI Securities.
What did you think about the delisting process? Let us know.
Finshots Recommends 
This week’s recommendation is The Margin Call.
A tense and suspenseful thriller that unfolds over 24 hours, revealing the morally ambiguous decisions made by an investment firm during the onset of a devastating financial crisis.
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