The next decision-making error we’ll look at is a phenomenon known as anchoring, which all too often clouds our judgment regarding investment decision-making.
So what is anchoring exactly? Well, as we’ve discussed, humans use mental shortcuts to help process vast amounts of information rapidly and subsequently make expeditious decisions. Anchoring is one such shortcut. The human brain tends to select an initial reference point and base decisions around that point. For example, when a salesperson sets an initial price for an item, they typically set it higher than the item’s real value to extract the highest possible price by placing an anchor in the consumer’s mind. During the bargaining process, the initial asking price (or anchor) sets the initial tone for what the item might be worth, and any final price is set with the initial anchor in mind.
You’ll recall this relates to framing, a cognitive bias that we discussed earlier. Humans evaluate outcomes in terms of losses and gains from an original starting point, which can be cleverly manipulated by a salesperson to be an arbitrary anchor, often valued above the item’s actual price in question. This is done so that they have room to move during negotiations and still end up achieving a high price while simultaneously leaving the consumer feeling they “got a deal”.
For example, a home may be quoted by a real estate agent as having a price guide of $1m. The vendor may well be satisfied with $850k, which may be closer to the home’s real value. But setting that $1m anchor in the minds of prospective buyers is no accident. Suppose a buyer ends up purchasing the property for $925k. In that case, they may well feel they got a bargain because they are comparing the result with the anchor (initial reference point), even though that figure ($1m) was somewhat arbitrary to begin with and designed to inflate the value of the property.
To demonstrate how this mental shortcut can be a pitfall to sound investing, consider an investor who sees a stock fall substantially from its highs and goes to purchase it to do a bit of what we call bottom fishing or bargain hunting. For those who have been around the market a while, Babcock & Brown (BNB) makes for a good example. The stock listed in 2004 and was a market darling from the get-go. The share price doubled in no time, from under $10 a share to around $20 a share less than a year later. Two years after that (in 2007), the stock was trading at nearly $35 a share, with a market capitalisation of approximately $10bn.
Then the GFC happened. The stock price started to decline along with the rest of the market, which was no surprise. But the problem for many investors was that a ~$30 share price became their anchor or reference point for the stock’s real value. As such, when the stock hit around $10 in mid-2008, they thought they were getting the bargain of a lifetime in buying at that price. The rest is history, as the company ended up collapsing only a few months later, stunning the investment community.
Now, of course, lots of once well-renowned companies have vanished during market crises. But the problem with BNB was that investors were using only the initial reference point (the anchor), being a share price of ~$30, as evidence of value, so in comparison, the price of $10 seemed very cheap. Many companies saw collapsing share prices (Macquarie Bank (MQG) was a good example); however, their fundamentals were more robust, so they outlasted the crisis and lived to tell the story today. Do not rely on an anchor point as evidence of value. Conduct a fundamental analysis of the stock and let that help guide your understanding of the company’s actual value.
Hopefully, this example demonstrates the dangers of emphasising the anchor. It is natural for the brain to select an anchor (as a shortcut) on which to base decisions, but try not to let anchors influence your decision-making when investing.
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