Overcoming Your Wealth Destroying Instincts and Becoming a Better Investor II - Anchoring Bias

Have you ever purchased a product or service based on an outsized focus (obsession) on one particular aspect of the product that really had no relevance to its usefulness? Like the very used Chevy Camaro you bought in high school with the hard earned $500 you’d saved from five summers of mowing lawns because you couldn’t resist the candy apple red paint job. The fact that the car was a mechanical disaster just seemed to pass you by. Don’t feel bad, we’ve all done that. In fact, we do it all the time but usually in far subtler ways. Psychologists call it “Anchoring Bias”, or the tendency of humans, when making a decision, to anchor our thoughts to a reference point even though, disturbingly often, it has no real relevance to the decision.

In 1974, the founders of behavioral economics, Kahneman and Tversky used a clever experiment to demonstrate the power that anchoring has in human decision making. They had participants spin a wheel with numbers from 1 to 100. Participants were then asked a question requiring then to make an estimate such as “What is the percentage of UN membership accounted for by African countries”. When the wheel came up on a higher number the estimate was on average much higher than when the wheel came up on a lower number. Obviously the spin of the wheel, a completely random number unrelated to the question, had a great influence on the participant’s response. They were anchoring on a recently experienced number to evaluate a problem.

Although the evolutionary basis of anchoring is the subject of much debate, it seems obvious that it was important to our not–so- distant hunter-gatherer ancestors to be able to make decisions such as what to eat, when to run, what critters not to mess with, etc. very quickly. The process that developed seems to base much decision making on reference points, or anchors. So our brains are constantly searching for these anchors. This is an almost totally unconscious process.

In our financial lives anchoring on the wrong information can get us in a lot of trouble. The way our brains process information worked extremely well when the anchors were unambiguous. Not so much today when so much information has little or no bearing on the true nature of the problem of the moment. Take for instance a sudden drop in the price of a stock. Many investors will buy it immediately without evaluating the reason for the drop. They anchor on the previous high price and the company looks like a bargain at the current price. Likewise, investors who own the stock already tend to hold on regardless of the news assuming that “it’ll come back”. In fact, an event or events may have transpired that makes the lower price a truer reflection of the value of the company. Perhaps the company’s product is becoming obsolete or a competitor has developed a less expensive manufacturing process and can now significantly under price the company’s product. In any case, basing your decision on the higher price alone will cause you much grief even though our natural tendency may be to do so. Successful investors like Warren Buffet are able to anchor on data that are relevant to the problem and effective in determining the true value of the company given its current situation and its future.

Perhaps nowhere is anchoring more apparent, or more damaging, than in the case of a great many small investors who use the current market value of their portfolios as a mental anchor. Thus during booms when their portfolios reach x number of dollars, they equate this to the true value of their investment holdings. This may or may not be the case as the value may have been artificially inflated by a temporary euphoria for risky assets. Then when the value drops because market participants are willing to take less risk they feel cheated out of their wealth and get angry or fearful and sell when in fact the value of their holdings may now be more reasonably priced to their true worth.

So, when making investment decisions how do we overcome our innate anchoring bias? The first step is realizing that it exists, and make a conscious effort to be sure that our value judgments are made on rational and relevant data points and not arbitrary ones. For instance when considering a stock purchase we should be looking for clues to what the true value of the company is, for example as determined by discounted cash flow or dividend discount calculations. The 52- week high or any other price the stock has obtained is irrelevant. The relevant question is “Is the price we are paying reasonable given the value we are getting?”

If you are a mutual fund investor what is important is not that we own the hottest performing funds of the past year. The decision to buy a mutual fund should be based on the role the fund plays in your portfolio allocation, the investment technique and philosophy of the manager, and the fund’s long term track record compared to its peer group. These are the data points that you should be “anchoring” on.