Anchoring Bias – Focusing too much on one piece of information when making decisions


Anchoring Bias – Focusing too much on one piece of information when making decisions

                                

Anchoring Bias is the act of basing a judgment on a familiar reference point that is incomplete or irrelevant to the problem that is being solved. An example is when a consumer judges the relative value of a product or service from a company on the basis of the cost in some previous period of time. Or, an investor may judge that a stock price is overvalued or undervalued based on that stock’s previous high share price.

http://www.businessdictionary.com/definition/anchoring-bias.html

The concept of anchoring draws on the tendency to attach or “anchor” our thoughts to a reference point – even though it may have no logical relevance to the decision at hand.

www.investopedia.com

Anchoring Bias in Stock Market investments

Some investors will have an attraction towards a stock which has fallen considerably from their previous or all time highs – say even from a 52 week high.

The investor is anchoring on the high prices that the stock has reached and now believes this provides an investment opportunity.

If the fall is due to overall market sentiment and not due to any deterioration in business fundamentals then the investor has made a right decision. But, if it is otherwise the investor will stand to loose a substantial amount of capital soon.

Few times investors also would anchor to a price only below which they will buy.

By this they may miss the opportunity to invest.

For instance, someone may want to buy stock X at Rs.500 or below but the price moved to Rs.550 and hence wanted to wait to come down to their anchored price (Rs.500). But, the stock further moved up to 600 and then 700. The investor would never buy that stock and in next few years it would have reached 1000 or even more.

Here, clearly the investor has missed the opportunity. He should have only checked the fundamentals and margin of safety and if the price was right even at 700, should have bought it.

Similarly, investors will hold on to a price for selling. They want to sell a stock only if it reaches a certain price or a target (all time high etc.,).

For example, an investor has bought a stock at Rs.500 (which has fallen from its all-time high of Rs.1000). He may anchor his price at Rs.1000 to sell the stock. Even if the price reaches 800, the investor will not check the fundamentals and compare to the current price and decide to sell. He may just hold on to it to reach Rs.1000. But, the stock may fall to 500 and 400 and 300, but he may not sell and instead may accumulate more to sell at Rs.1000, the price which the stock may never reach in a decade too.

My personal experience

During the 2008 – 09 financial crisis, most businesses were knocked down to rock bottom prices. Among them were several jems with strong fundamentals, which were also pulled down due to market sentiments and fund outflows. Few of them were Asian paints, HUL, Nestle, HDFC Bank etc.,

At that time, I was always anchored to a certain PE and PB Ratio – I will hesitate to buy stocks that were trading above 18 PE and 2 PB ratios, assuming those would not provide not enough margin of safety.

Hence, I missed several opportunities to buy into great businesses which, even though were beaten down, but, did not come below my anchored PE and PB ratios

One example was Nestle, which closed at 1400+ in early Jan 2009. When I checked the PE it was trading at around 21+ and double digits of PB ratio. Hence, I did not but that business and hence lost a great opportunity. Today, as of writing this post, Nestle is trading at 5000.

Another example was HUL, which closed at 215+ in early March 2009. When I checked the PE it was trading above 20+ and double digits of PB ratio. Hence, I did not but that business and hence lost a great opportunity. Today, as of writing this post, Nestle is trading at 600.

Lesson learnt – Never anchor to any specific number. Be it a price, or valuation ratios etc.,

Check only the underlying fundamentals and if it is a great business, go ahead and buy, even if you have a reasonably fair enough margin of safety. Because, great businesses very rarely trade at mouth-watering valuations. Moreover, they will always trade at higher valuations, because of its future prospects derived from its moat and durable competitive advantages. This is also reiterated by Mr.Sanjay Bakshi in his recent interview to a magazine.

http://business.outlookindia.com/article_v3.aspx?artid=285698

How to avoid Anchoring Bias

  • Just understand that these types of biases exist and evaluate if you are caught in this bias
  • Focus only on fundamentals and not the price alone
  • Just be patient and check once if you are making an emotional decision or a data driven decision
  • Discuss with trusted resources, even to be specific ‘devil’s advocates’ to take a critical thinking view

“To reach a port, we must sail. Sail, not tie at anchor. Sail, not drift” – Franklin D Roosevelt

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Filed under Behavioural Finance

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