Block 16: Anchoring Bias
Welcome to psychological biases. A bias is something that prevents you from making an optimal decision. Have you ever tried to fix something and it just wasn’t working out but then you continued working on it for the sole reason that you had already put so much time into it? If so, you are familiar with biases. We all have them so let’s try our best to put a stop to ‘em!
The first investing bias we will look at is the anchoring bias. Pretend an investor buys two shares of stock, each worth $100. One Benjamin Franklin into Company A, the other in Company B. Company A’s price soon increases to $120. Hey, not bad! A 20% return! During the same period, Company B goes to $80, a negative 20% return. Ouch! What should our investor do?
Well, if he is like most people he will sell the profits of Company A and put the proceeds into Company B since it is “cheaper” and will lower the cost basis (the price you pay). However, our investor is falling prey to a little know bias called “anchoring.”
Anchoring is fixating to the price you paid or will pay for a stock. Selling a stock that went up and buying one that went down is like cutting your flowers and watering your weeds if you’re a gardener. Usually there is a business-related reason the stock increased and likewise for why a stock went down. If there is no business result associated then our imaginary investor may have made the right decision.
Here’s another example. An up-and-coming fast-growing company IPO’s at $10 per share and soon rockets to $25. Wow! That’s crazy. However, when you evaluate the stock you think it is a pretty great company and a solid investment even with the meteoric rise. You go ahead and buy some shares. You tell your friend and he exclaims, “What are you doing? The stock has more than doubled!!” He has fallen prey to the anchoring bias. He is anchoring to the $10 IPO price. You, instead, made the optimal decision and evaluated the investment based on the current situation and where it can go in the future. That is the key to combatting anchoring. Look to the future. And not the past. (p.s. we will talk more about how you can evaluate the investment and make your own decisions later…)