Anchoring is a common cognitive bias that influences how investors make decisions. It refers to the tendency to rely too heavily on the first piece of information offered when making judgments, even if that information is irrelevant to the decision at hand. Anchoring can cause investors to be overconfident in their assessment of value, cling to losing trades too long, and engage in excessive trading. Understanding anchoring bias is the first step to overcoming it. This article will elaborate on how anchoring affects investing decisions, illustrate with real-world examples, and offer suggestions to minimize its impact.
Anchoring leads to biased assessments of value
When estimating the value of an asset, investors often anchor to the current market price or some other readily available number. This anchoring price serves as a mental reference point, causing investors to inadequately adjust away from it. As a result, stocks that have risen in price start to look expensive only at much higher levels than justified. Conversely, falling stocks look cheap only at much lower prices. Anchoring bias causes investors to be slow in responding to new information about fundamentals.
Anchoring prolongs commitment to losing investments
The purchase price of a stock serves as a natural anchor for investors. When a stock falls in value after purchase, the investor anchored to the higher purchase price stays committed to the investment for too long, hoping to break even. This reluctance to realize losses is further exacerbated by loss aversion. On the other hand, gains are anchored as well, with investors selling winners too early to lock in gains. Overall, anchoring on purchase prices hurts investment performance.
Anchoring encourages excessive trading
Anchoring to arbitrary price levels encourages excessive trading. Investors try to exploit perceived mispricings around anchors such as 52-week highs/lows, whole numbers, or other technical indicators. But stocks near anchors are no more likely to be mispriced than other stocks. Trading anchored prices simply results in extra transaction costs without any real benefit.
Ways to overcome anchoring bias
The first step in overcoming anchoring is to be aware of its influence. When making investment decisions, consciously question where your anchor point comes from and whether it holds any relevance. Seek out contrarian perspectives that challenge your anchored thinking. Set rules and stick to them, rather than making discretionary judgment calls. For example, use stop-losses for losing trades instead of waiting indefinitely to break even. Establishing and adhering to a sound investment process minimizes the impacts of bias.
In summary, anchoring is a significant behavioral bias affecting investing decisions. Investors anchored to irrelevant price points tend to misestimate value, hold losing trades too long, and trade excessively. Recognizing situations where anchoring occurs and establishing rules and processes can help overcome this bias.