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Anchoring as a Self Defeating Psychological Bias in Trading
The other day, I was conducting a training session on the psychological aspects of investment to a group of financial advisers.
Being able to control some of these psychological elements go a long way towards differentiating a successful investor from an unsuccessful one.
This is something that is easier said than done but for a start, it is good to be aware of some of these factors (often self-defeating) that exists in all of us.
“Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” ~ Warren Buffett
In this post, I will talk about anchoring, one common psychological aspect that affects everyone.
Anchoring is the use of past (and irrelevant) information to decide on something in the future.
I will focus more on price anchoring, which is the emotional attachment people have to the price of an investment.
Often, when faced with a loss, many traders or speculators will pray hard for the price to reach their purchase price before they are willing to let go of their investment. If the price stays below their purchase price for a long time, inevitably they end up being long-term investors (even though the original plan was to make a short term trade).
The purchase price serves as an irrelevant anchor that results in sub-optimal results for most investors.
Logically, the decision to buy, hold or sell at any one time should depend on two key factors:
- At this point of time, is the price more likely to go up or down?
- If I sell off this investment, are there better opportunities to deploy my money elsewhere?
For traders (especially those on leverage), keeping the first point in mind would be very useful. If you know the price is very likely to go down, why do you want to continue holding on to a long position? If the price of a stock is $1 and it is going down, it doesn’t matter whether you bought it at $0.80 or $1.20. The logical thing would be to sell. The market doesn’t care what price you purchased your investment and neither should you be fixated with it.
For investors, the second point can sometimes help you make a better decision. Let’s say you bought at company X at $1 and it falls to $0.80. While you are confident the price will ultimately recover and even reach about $1.20 in two years’ time, it is better not to look at an individual stock in isolation. Suppose there is another company Y that is also trading at $0.80. You gauge that company Y has a decent chance to double or even triple in two years’ time. Assuming you have no more capital to invest into Y and you only hold X, then it is logical to sell all the X you have and buy Y.
Often, after a severe market correction, there are many opportunities to do this kind of tactical switching but because people are anchored to their purchase price and want to prevent “realizing a loss”, they will usually do nothing and miss out on many wonderful opportunities.
Another way that price anchoring can affect us is when we buy a stock at $1, sell it at $1.20 and it continues to rise to $1.40. There is regret in selling so early and we will tell ourselves that if the price comes back to $1.20 or below, we will buy again.
Or another example where we want to buy a stock at $1.20, fail to buy any and the price rises to $1.40. We tell ourselves that we will surely buy if it drops back to $1.20 again.
This fixation with the price level of $1.20 in both cases is really an arbitrary figure that is completely irrelevant other than to make us feel “right” in our earlier decision to sell or wait.
Another form of anchoring is the use of 52-week highs or lows as reference points without considering all the other factors. “The highest price used to be $10, it is cheap now as it is only $6.”
Not letting price anchoring influence our trading or investment decision is something that is easier said than done. Even though I know that the times when I have managed to ignore price anchoring are times that result in a positive contribute to my returns, sometimes I will still keep various price levels at the back of my head.
However, I do find that generally I am pretty decisive when it comes to tactical switching and over time, I am also getting better at cutting losses on my trading positions.
Keeping in mind the two key factors that I pointed out above will go a long way towards helping you get rid of any price anchoring that you might have and make the correct investment decision.