Anchoring: What it is, and Why it is Bad for Investors

Anchoring: What it is, and Why it is Bad for Investors

Traditionally the “anchoring fallacy” (also known as the anchoring bias) is understood as taking one single piece of information we receive and drawing a conclusion from it. A good short video explaining why this behaviour is common, but still a fallacy, can be found here.

In investing this fallacy happens when we are given a price point and, based on that arbitrary number, we then decide how much something is worth. This can do damage to our portfolio in several ways, but two are especially common.

Getting back to “even”

The first happens when we make an investment, and it starts to go down. As the owner, we then decide that we will not sell that asset until it gets back to the price we paid (or some value it had at some point in time). Essentially, we have put an anchor on this arbitrary price, which is not really based on logic or reason.

A better question to ask is “why has the price declined?” As with many misbeliefs, we need to combat this one by remembering the difference between the value of a company and the price that it is trading at right now. And if we are doing investing right, we will be buying those companies that are trading below their value and selling the ones that are trading above it.

As counterintuitive as it may sound, the price of something at a point in time must never be a factor in whether we need to sell it now, buy more, or wait until the price goes higher before selling. Our purchase price, for example, represents what we thought the value was at the moment we bought it. Nothing more, nothing less.

Another example of anchoring (and something we are seeing in Canada right now) is changes in real estate. Homeowners buy a home and the value of the home decreases in value. When wanting to sell that piece of real estate homeowners may decide to “wait out” the market until they see the value of their home increase (or at least break even). This is a type of anchoring; rather than accepting the loss and moving on, you see individuals waiting in hopes of a better price even if that is not what the real estate market is projecting. This can ultimately delay the sale,  which could result in loss of money from carrying two mortgages or missing out on their new dream home while waiting out the market.

The target price is…

It is not unusual to invest in a stock or bond with an expected future target price in mind. Most stock market tracking sites even publish the consensus one-year target price for that stock on their web page. If the target price is higher than the current price then it must be a good investment, right?

Again, this will depend, but if we decide to anchor our expected future rate of return to the target price then we have just attached an anchor to it. There is nothing wrong with having a targeted rate of return on a portfolio, or even a specific investment. But we must always remember to evaluate that target on an ongoing basis as we learn new information. Is the economy growing or shrinking? Has a new competitor entered the market (or left)? Did the company make a bold new acquisition that will help them grow? All sorts of events and new facts will come to light throughout ownership in an investment. Through it all, we need to keep our investor eye on the value of the investment. Not the price it once traded at, nor on what the market consensus thinks it will trade at in the future.

Conclusion

Anchoring can be one of the most damaging fallacies any investor can commit. The arbitrary nature of the price chosen for the anchor cannot be used as a gauge for what an investment will be worth in the future, or even what it is worth today. For that, we need to do a deeper analysis, determine the true value of the company, and continue to monitor the factors affecting that company as time progresses. Only then can we be successful over the long term. And this is where we can help.

Both CH and our investment partners remain focused on finding value in the market at attractive prices. This is the only way to make sure we avoid damaging behaviors like anchoring for our clients. It also helps us to make sure we are not selling things below their actual value, nor buying into companies that are trading above those values.

All the best,

Brian Trafford, Chief Investment Officer

& Your CH Financial Team

403-237-6570

hi@chfinancial.ca

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