Anchoring Bias: The Hidden Weight on Your Investment Decisions
I spend a lot of my time on the road. Despite having warm coffee to keep me alert and the company of my favorite tunes streaming from my phone, I occasionally get bored. It's really dumb when I think about it. I have the freedom to move from one place to the next, traveling quickly and safely (most of the time). What could I possibly have to complain about (besides bad drivers, traffic jams, poorly marked streets, and radar patrolling law enforcement)?
Transportation wasn’t always so easy. Innovation, over millennia, has led us to an era of transcontinental flight, electric vehicles, ocean voyages, and space travel. The creation of new modes of travel likely started with the daunting task of traversing water. It’s believed that hollowed-out tree trunks made the first boats over 8,000 years ago.
Any good boat captain knows the importance of a quality anchor. The earliest water navigators probably struggled with drift much like we do, minus the Yeti coolers of adult beverages. Not to be deterred, these early skippers likely took a heavy rock, tied it to thin tree branches, and created the first anchor. Hundreds of generations of intoxicated lake goers owe a debt of gratitude.
More recently, economists used the anchor to describe a cognitive bias that impacts investor decision-making.
Anchoring describes the tendency to attach views to information that may not be relevant to investment decisions. The unquenchable thirst for data makes anchoring an easy trap to fall into.
Here are three common points that commonly tempt investors to anchor:
Purchase Price :
When we pull the trigger on an investment (after completing the appropriate due diligence), the purchase price is burned deep into our memory bank. When the price rises above that price, we’re elated, feeling justified in our decision. However, when the price sinks below it, a sense of dread overwhelms us.
Suppose you paid $100 a share, and the price plummeted after the company announced unexpected challenges to their business. Even if your original investment thesis was busted by this new revelation, anchoring to the purchase price could erroneously lead you to conclude the company is undervalued and hold in hopes of returning to the $100 anchor.
Recent high (52wk high) :
Like the tide, stocks move up and down in the short term. This short-term volatility is described as the price of admission and is a boon to the financial media, which constantly uses anchors to dramatize short-term gyrations. If you turn on a business network and watch longer than five minutes, you'll likely hear an analyst upgrade or downgrade a stock, using the 52wk high (or low) as justification.
It often goes something like, "XYZ is looking like a real bargain here. Their 12% off their 52wk high, and this pullback looks like a real buying opportunity. We like the stock."
The 52wk high is irrelevant.
Perhaps the stock is trading at an attractive price, but that has nothing to do with its previous highs or lows.
The price could never hit that high again if the company fails to execute its business plan, is outmaneuvered by competitors, faces tough, new regulations, or becomes entangled in scandal. The stock price could also soar past that short-term peak. Yet, time and time again, the 52wk high is used as if it is relevant to investment decisions or the future.
Jan 1st (year-to-date):
For most investors, how a stock has performed, year-to-date is meaningless. Year-to-date performance is touted even before the first quarter is over. This time frame anchor is usually used to intensify debates about various companies or industries or for investors to compare companies, sectors, or industries.
Anchoring to irrelevant dates and prices can create a drag on performance and distract investors.
How to Avoid Anchoring
Beware of dogmatic analysts and pundits: I'm skeptical anytime someone yells passionately about a particular stock, especially if they are focused more on price than the company and its products and services. Media outlets sensationalize stories and have short time horizons. They don't exist to help us make better decisions; they exist to grow their audience. When a pundit uses arbitrary dates and numbers to paint a picture, take it with a grain of salt. Do your own research, or work with a professional who has your interests in mind.
Form good habits: dollar-cost averaging, using an investment checklist, and journaling your investment decisions can be suitable defenses against anchoring bias (and other mistakes).
Invest for the long term: when less worried about short-term performance and more interested in achieving long-term goals, you become less susceptible to anchoring bias. Always consider your time horizon and objectives when making investment decisions.
Anchors were a boon to ancient merchants and modern boaters alike, but they can weigh down investment returns. Investment decisions should be based on relevant information, critical thinking, and due diligence, not anchoring to incidental time-frames and prices.
If you are making forecasts about the future, be mindful and always ask, "is my estimation rational, or am I anchoring?" Avoiding or just improving your tendency to anchor could help you make better investment and financial decisions, improving your odds of achieving your long-term goals.
