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  • Writer's pictureRyan

Needing New Tools

In life and investing, oftentimes it’s not enough to just tell someone that they should change their behavior. Without a new frame of reference, simply telling someone what they should do, falls short.

To be more specific, just telling a close friend that they need to stop spending money and invest in the stock market, likely won’t result in the new desired behavior. If the advice is too general, there’s nothing for the new knowledge to latch onto. I view advice almost like a snowball rolling down a hill. The more context you have (the bigger the snowball), the easier you can integrate advice into your existing frameworks and the snowball gets bigger and bigger. But at the beginning, before the snowball has rolled at all, it doesn’t have enough momentum to absorb other fragments of snow.

Now, I’ll step off my philosopher soapbox.

One key example of this with investing is anchoring. It’s easy to tell someone: don’t anchor to stock prices. But, without a new tool for dealing with anchoring when it inevitably arises, it’s tough to follow the generic advice. (I haven’t defined anchoring yet but it’s when you attach to a price and let that inform your decision).

Picture this.

You find an interesting stock and you decide you’d like to buy it, you check the price and it’s up 10% on the day. What do you do? Well, you don’t want to anchor but it just feels wrong to buy the stock when it’s already up so much. How do you get over that feeling?

Well, one option is you can just trust the advice. You received advice from a trusted source or you have just observed over the years that anchoring is counterproductive, and therefore, you just need to get over the feeling.

In my experience, without knowing “the why” behind the advice, it’s very difficult to follow it. And I think this gets to the heart of it. Oftentimes advice is spouted but without the underlying reason for why the world works that way. When we find someone who can explain the underlying “whys” we are drawn to them. It’s like a cheat-code for life.

I think the reason why advice is rarely accompanied with the reasons for why something works is because we often don’t know or haven’t dug deep enough to understand. Reality is often deeply complex so it takes a lot of time and energy to figure out why things work the way they do. In fact, it wouldn’t be feasible for us to understand the “whys” of everything. It would take all of our time when, for most things, the fact that things are the way that they are is good enough.

Even a simple thing like why the sky is blue is pretty complex if you really get into it. But only a select number of people really care about that. Most of us are content with the fact that it’s blue and that’s all we need to know.

But when we really understand how something works, it’s so much easier to know how to react. So let’s get into it: why is anchoring not a good idea?

To understand, we must go to the underlying mechanics. Anchoring isn’t a good idea because of the reality of how the stock market works. When you buy a stock, you don’t get any participation in the past gains – only the future ones. Therefore, the key input is not what the stock has done, but what it will do in the future. Now you may argue that the past price movements hint about what the stock will do in the future. And yes, you might be right. The thing is that when you look at the data, on a short-term horizon (less than 1 year), stocks that are going up are more likely to continue going up and vice versa, stocks that are falling are more likely to continue doing so.

So if you were to anchor to a lower stock price and refuse to buy it at higher prices, then you would actually be making the statistically incorrect decision on a short-term basis.

But why is this the case? Well, there may be multiple reasons. Stocks with high relative strength (aka they are going up a lot) may signal that there is institutional demand or that momentum traders are piling into the stock. Or it may mean that the fundamentals are firing on all cylinders and that the previous stock price was much too cheap. Or that there is some macro event that people think will be helpful to the company. But oftentimes, stocks don’t just go up for no reason. In reality, stocks go up because there is more demand for the shares. People who are holding shares aren’t willing to part with them at lower prices and require higher prices to sell. It’s all supply and demand. Low supply means that fewer people are selling. And when fewer people are selling, buyers must offer higher prices to entice the holders of the shares to sell. These mechanics drive the actual price movements, just like in any market.

So why would someone hold onto an asset or offer a higher price than it’s currently worth? Because they think the price will be higher in the future. Different parties have different reasons for why they might think this – traders might just be speculating that things are going in the right direction and long-term investors may be doing their DCF models – but it remains, they think it’s going higher at some point.

I believe that, in the long run, prices go up because of fundamentals. Momentum traders are only piling in because the price is up. That usually doesn’t just happen for no reason (though I might have to make some caveats with things like GameStop and AMC). So when a company crushes its earnings report, the stock might explode higher because people now think the company will be more valuable than they previously thought. In between earnings reports, investors speculate based on credit card info, macro reports, trends for other companies’ earnings reports, etc. to guess what the variance will be – between the expectations and the reality of the results. When you add it all up, these short-term games drive prices in the long term. The funny thing is that there is just so much noise between earnings reports. A skilled investor will have a better idea about what matters and what doesn’t and she will be able to filter out the news that should go right in the trash can and the news that is important (as an aside, the news is rarely important).

But if you try to focus on short-term games, you can lose sight of the longer-term. If a company is trading at a $5 billion market cap, but you think it will do $10 billion in free cash flow in 5 years, you can be pretty sure that today represents a good price. But each earnings report can either point towards confirming or denying the original hypothesis. Some investors call this is a “thesis.” It’s really sort of like a crude form of science. You create a hypothesis and then the results can begin to provide evidence if that hypothesis is on track. Actual scientists may cringe at this comparison, but the general point remains – you have something in mind that you want to test and there are pieces of evidence that can confirm or deny the original hypothesis. Confirmation bias comes into play when we want to believe our hypothesis is true even when the body of evidence points to it not being true.

So you have this hypothesis in mind but sometimes, the evidence isn’t very clear. For instance, a company can just barely miss guidance. Should that require an immediate sell? Or was the variance low enough where the hypothesis is still intact? This is a tricky topic and depends on people’s time horizons and style (we can discuss this in another post).

All of this is really the art of valuation; having a hypothesis for the future of the business and then understanding what is priced into the stock. As the company reports its results, you have to make the decision as to whether the hypothesis is still on track. And then there are thousands of potential experiments you can run (different companies) and you need to decide which experiments will yield the highest returns.

Sometimes an experiment’s hypothesis looks like it’s right on track but then one piece of evidence seems to invalidate it altogether. When there are other experiments that seem like they will offer better returns, it makes sense to switch. But then there are also other considerations like how you don’t know the new experiment as well and there are costs (taxes) to switching. Like reality, it’s always complex but you need to know why you’re doing what you’re doing. Then, it’s easier to react.

And now we’ve come full-circle – back to the beginning. If a stock is up a lot, anchoring isn’t a good idea because it would likely be such a small piece of evidence in the whole scheme of the experiment’s hypothesis (this post isn’t about how to make those hypotheses but it’s the whole research process from analyzing management, the industry dynamics and tailwinds, advantages, company culture, etc. It’s all in service of strengthening or weakening the conviction in your hypothesis).

If you think a stock will 3x over 5 years, a 5% jump in the price lowers your expected return by a fairly small amount. Let’s do the math.

If your hypothesis is that a $1 billion company could become $3 billion in 5 years, the CAGR would be 24.6%. A 5% jump in price means $1 billion turns into $1.05 billion. So the CAGR goes from 24.6% to 23.4%.

So if a 1% decline in expected annual return invalidates everything, then a) you might have a lot of other high-return experiments or b) you might not have much conviction to begin with.

In this light, overcoming anchoring can be turned from an emotional thing to a rational one. Rather than just heeding the advice that anchoring is bad, you have a full framework for why anchoring is probably suboptimal for your returns.

But that’s the thing. Here we are almost 1,800 words later. Even a small thing is complex when you dig down a couple of layers. Here’s to thinking just a little better each and every day! The result will almost inevitably be better long-term returns.


 

Thanks for reading! Feel free to reach out at ryan@investingcity.org anytime!

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