Stable Investor’s note: Today’s guest post by Daniel Sparks covers an important topic of Anchoring Bias in investment decisions.
The study of how psychology affects our investment decisions is, rightly so, becoming more and more important. It has even been given a formal name: Behavioral Finance. Do we have to get an MBA or take a psychology class to understand the implications of behavioral finance on our investment decisions? Definitely not. We will have a huge advantage by simply recognizing and understanding the most threatening psychological bias to every investor: the anchoring bias.
Consider this common scenario:
John buys shares at $30. 2 months later the same shares are trading at $25. He holds on to the stock because he remembers that he originally paid $30 a share and he doesn’t want to lose money. He keeps holding and the stock drops to $20 a share. He freaks out and sells.
This is a perfect example of how deadly the anchoring bias can be. No matter how smart we are (or think we are!), the anchoring bias can be a serious threat if we don’t show it some reverence.
This scenario reminds me of a time when during one of my MBA classes the professor asked the students, “Does the price you paid for your house matter when you are selling your house?” Surprisingly, more than half of those who responded said, “Yes.” This is, once again, a perfect example of the anchoring bias in full affect. No matter how educated you are, it can still affect you.
When we are making a financial decision today, all that matters is one thing: value. The price you paid for a house, or the price you paid for a stock 1 year ago means nothing about value today.
So what exactly is the anchoring bias?
Anchoring bias: focusing too intensely on one piece of information or trait when making decisions.
So how can we avoid the anchoring bias in making investment decisions?
1. Show it reverence: studies show that simply recognizing the possibility of human bias and understanding our tendencies to be irrational will help us overcome biases.
2. Ignore what a stock has done in the past: focus on fundamentals and pretend like you are considering the business as a whole as if it is not publicly traded—this applies to selling and buying.
3. Be patient when making financial decisions: If the stock has moved up or down and you are tempted to sell or buy, make sure you are not tempted to make this decision simply because you are anchoring on what the price was before.
About the Author: Daniel Sparks has a passion for Value Investing and is a big believer in investing only in companies with a durable competitive advantage. He has served in US Army and is a part of Colorado State University. Read more about him at Value Folio.