How Anchoring Sets You Adrift

By The Noble Contrarian on March 7, 2011 in Other

Sharemarket investors and boat-owners, you might be surprised to learn, have something in common (other than an unfortunate tendency to buy dud investments). Over time, each becomes accustomed to anchoring.

For the boat-owners, anchoring is something to be mastered (the rest of us might find that The Complete Book of Anchoring and Mooring could cure insomnia). But for the investor, anchoring is a common psychological bias that one should strive to avoid.

Quite simply, anchoring is the tendency to focus on irrelevant information (that is, we ‘anchor’, or attach ourselves, to it). We then use this information, incorrectly, to help make decisions.

If you invest in the stockmarket, you no doubt know the feeling. You have a stock that you wish to sell, the current price is $3.90, but you’re waiting for the stock price to get back to the $4.00 it traded at last week before you sell. Or there’s a stock you want to buy, which you know is cheap, but you saw it trading at $1.00 a month ago and now $1.20 feels like too much.

We do it with stocks. We do it with houses. And we also do it with clothes, shoes and beers at the pub (how bad does the first shout after happy hour feel?).

Pioneering behavioural psychologists Amos Tversky and Daniel Kahneman first tested the theory of psychological anchoring in 1974. In their experiment, they asked one group of participants whether the percentage of African nations in the UN was more or less than 10% and a second group whether it was more or less than 65%. Then they asked both groups what they thought the actual percentages were. Those who had first been asked whether it was more or less than 10% guessed 25% on average. Those who were given the anchor of 65% guessed 45% on average.

James Montier, in his door-stop-sized tome Behavioural Investing, summed it up thus: “When faced with uncertainty, we have a tendency to grab on to the irrelevant as a crutch. The incorporation of the irrelevant often happens without any conscious acknowledgement at all”.

Montier makes two points worth dwelling on. First, we often don’t realise we’re doing it. Second, anchoring occurs because investing is an inherently uncertain and complex activity. Human beings are attracted to certainty and precision. We therefore become fixated on exact numbers like purchase prices, price-to-earnings ratios, profit forecasts, or oh-so-precise discounted cashflow valuations. These numbers help paint a picture. But placing emphasis on too few of them over-simplifies the story.

Like most psychological pitfalls, the best thing you can do is understand yourself and how vulnerable and ill-equipped your brain is for the modern world. It evolved over hundreds of thousands of years to survive in a hunter-gatherer world where all you needed to worry about was food for the next year, at the most. Now you’re asking it to prepare for retirement 50 years hence and deal with a range of potential outcomes unfathomable to our predecessors.

So next time you’re weighing up a decision and there’s a number in your head, just ask yourself whether it’s relevant.