Behavioral biases found in almost all investors, both private and professional, are often exhibited by enduring habits, behaviors and biases that are very difficult to self identify. These are our bad decisions, the mistakes that we continue to make without even realizing that we are making them, or why.
Discipline is a valuable commodity when it comes to managing your personal finances, yet we often find ourselves stuck on a never ending road of bad decision making. We humans are hard-wired for recognizing patterns of behavior and making decisions on the patterns we see, but when it comes to investing real money in real markets, our vision and judgment may be clouded by a number of fact-patterns we could not anticipate, or worse, decided to ignore because our ego got in the way.
Our goal is not to become armchair psychologists; rather, we want to examine some of the most prevalent behaviors that can derail your portfolio, and offer ways to identify them and possible solutions.
Biased Behavior: Anchoring Bias
When we encounter new information, it often doesn’t make sense to us unless we’ve had some previous similar information to use as a reference point from which to evaluate and understand the new information.
To facilitate understanding the new information, we need an anchor, a reference point from which to start.
Anchoring is one of the cognitive biases that investors must deal with when making portfolio decisions.
Anchoring bias describes our tendency to rely too heavily on the initial or original piece of information when we make subsequent decisions. We may tend to want to stay close to the anchor when making these new decisions, and all new information is based on the old information we stored, i.e, the anchor. The more distant the new information pulls us away from our anchor, the tougher time we have with making the new decision.
..our ego got in the way…
That may often be a good thing. Anchoring enables us to make faster decisions when we have a reliable anchor. For instance, it takes no thought at all when we are being chased by a rabid racoon! Anchor says move your butt! You move your butt without a moment’s lapse in reaction time.
But it could work the other way, too. We often get attached to our anchors, placing unwarranted significance on this glorious morsel of data that has become a permanent fixture in the reference library between our ears.
In other words, our anchor may have lost its relevance to any new information that comes our way.
Anchoring Bias in Practice
Let’s say you are making one of the largest investments you can make in your life, buying a new home.
You see the “For Sale by Owner” sign on the front lawn of a house you’ve long admired in a nearby neighborhood. You love this house. You want this house. You call and the owner who says that he’s looking for $350,000.
Drop anchor! The asking price of $350,000 has set the standard for the negotiations to follow. In your mind, you are seeing a $350,000 house. It seems like a reasonable basis from which to start, and certainly homes in that neighborhood go for about that price, you tell yourself.
You meet the owner and through some pretty slick maneuvering on your part, you agree on a sale price of $323,900. You are some kind of negotiator!
What you knew yesterday may have completely lost relevance today.
In reality, the seller came in higher than market and, the lower agreed upon price, being much lower than the ask, seemed more reasonable even if the purchase price of the home is more than its really worth! Anchoring bias causes you to judge the relative value on the basis of the first price you heard.
So, be cautious. Your anchoring bias can lead you astray whether you are buying a piece of real estate, a pair of shoes, or shares of stock.
Regarding stocks, the share price of XYZ is now $35, which has little to do with the fact that a year ago it was $50, or whether an investment in XYZ makes sense at all!
Overcoming Anchoring Bias
Things change. Ask any warrior and he will tell you that battlefield conditions can change overnight. What you knew yesterday may have completely lost relevance today.
When you’re considering a new investment, consider the fundamentals of that investment today. Not last year. Not five years ago. Today.
The past counts for something, for sure, it provides context, but the past cannot be the anchor around which your new decisions are to be made.
If XYZ is actually down 30% from $50 to $35, why?
Do the fundamentals and outlook support the lower market valuation clawing its way back to former glory, or is there some systemic reason that makes this thing a slow dying dog?
If that’s the case, your anchor is the tail wagging that dog.
If you never owned XYZ before, then why would you allow yourself to drop anchor in the past, binding yourself to the psychology of needing to see the thing come back? It once being $50 has absolutely no bearing on a future price. Does it deserve to be there because it once was? Only the fundamentals can tell you, not being anchored to past prices.
Do your homework, work the fundamentals and make better decisions. Drop the anchor.
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