Anchoring bias is a common cognitive bias that impacts investing decisions. It refers to the tendency to rely too heavily on the initial piece of information when making decisions. Anchoring can cause investors to have a wrong perception of value, leading to poor investment choices. This article will illustrate anchoring bias in investing with real-world examples, analyze its harmful effects, and provide suggestions to overcome it. Proper understanding and mitigation of anchoring bias is crucial for investors to make rational investment decisions.
Anchoring to historical price levels
When building trading strategies, investors often pay close attention to historical price levels and use them as anchors. For example, in statistical arbitrage strategies between steel rebar and hot rolled coil futures, traders observe the historical price spread range and initiate trades when the current spread reaches historical extremes. However, relying solely on historical anchors could be detrimental. In October 2022, the rebar-coil spread consistently breached its historical lows, causing losses for traders anchoring to historical levels. Blindly anchoring to the past fails to account for changing market conditions like inventory levels, production schedules, and shifting supply-demand dynamics.
Anchoring to arbitrary reference points
Anchoring can also occur with arbitrary reference points that are logically irrelevant. In a study, investors were asked to estimate the number of doctors in London after writing down the last digits of their phone numbers. Those with higher last digits gave higher estimates than those with lower digits, anchoring to their irrelevant phone numbers. Similarly, investors often anchor to purchase prices when evaluating selling decisions, even if the purchase prices have no bearing on current fair value. This could lead to holding onto overvalued stocks for too long or selling undervalued stocks prematurely.
Anchoring to prominent market examples
When analyzing a new IPO, investors tend to compare against prominent market examples and anchor their valuation estimates. For instance, they may look at the current price of an established competitor and anchor the new issue’s value to that price, ignoring differences in fundamentals. Similarly, real estate appraisers often compare properties to a few recently sold ‘comparable properties’ in the vicinity, anchoring their appraisal to the sale prices of those comparables. This could result in overvalued or undervalued price opinions.
Mitigating anchoring bias in investing
Here are some suggestions to overcome anchoring bias: (1) Recognize when anchoring occurs by consciously questioning the relevance of the anchor and not letting it disproportionately influence decisions; (2) Seek objective data and valuations based on fundamentals like cash flows and growth projections; (3) Consider different anchors and perspectives, not just prominent ones that come to mind easily; (4) Use algorithms and rules-based processes to reduce individual biases; (5) Consult advisors to supply alternative viewpoints. While difficult to avoid completely, investors can minimize anchoring through awareness, critical thinking, and systems that anchor to fundamentals.
In conclusion, anchoring bias is prevalent in investing and can sway judgments by giving excessive weightage to irrelevant or arbitrary anchors. Investors need to be aware of this tendency and proactively mitigate its harmful effects through rational analysis and valuations based on market fundamentals and objective data.