The area of behavioral finance has gained a great deal of attention of the past decade. Once thought of as complete mysticism, it has become an integral part of the research into investor psychology and decision making. One are of common study is the study of anchoring. Many of us are susceptible to this psychological trait even though we are completely unaware of it.
First, a brief description of what anchoring is and how it impacts our decision making. One of the primary inputs to the anchoring process is exposure to meaningless or irrelevant information. The term “anchoring and adjustment” was used by Tversky and Kahneman (psychologist) in a study concerning human behavior and decision-making. William Poundstone described this study in his book, Priceless: The Myth of Fair Value. Here is a brief excerpt;
“Participants were asked a two part question – (1) is the percentage of African nations in the U.N. higher or lower than 65% and (2) what is the actual number of African nations in the U.N? A wheel of fortune was spun to provide a random number. Tversky and Kahneman theorized that an initial value (the ‘anchor’) serves as a mental benchmark or starting point for estimating an unknown quantity. In the study, a wheel of fortune number was the anchor. The first part of the questions has the subjects compare the anchor to the quantity to be estimated. Tversky believed that the subjects then mentally adjusted the anchor upward or downward to arrive at their answers to the second part of the question. The adjustment was inadequate. The answer ended up being closer to the anchor than it should be. The anchor exerts an almost magnetic attraction.”
Much of their work is incredibly relevant to the world of investing. We are anchored to irrelevant and meaningless information on a daily basis. We are most vulnerable when we come to believe this information as a basis for our investment thesis. For example, a company that has consistently grown earnings at 15% over the past ten years can cause us to improperly extrapolate. We may come to ‘count’ on this number for our forecasts of the future.
One impact of anchoring that was fascinating was how we are anchored by a company’s stock price. If you notice, most analysts will derive price targets by simply taking the existing price and adding 10 or 15%. They will adjust the target as the stock moves upward or downward. If you think about it, this seems totally insane. Yet this type of logic is applied all the time. How do we counter this vulnerability? The best and most obvious way is to completely ignore the market price. For instance, if one is interested in Apple Computer – don’t bother to check the stock chart. Rather take analyze the financials, market share data, the company’s product lineup and competitive position within the industry and growth prospects. Factor in all important data while leaving out current price. Arrive at the price to be paid as if it was a private enterprise. Then (and only then) compare your price to what the market is willing to offer. Backing into an acceptable price will go a long way to remain objective and anchor free.
