Don’t Sink the Ship with an Anchoring Bias

Are you anchored to a certain price where you will sell (or buy) an investment? Welcome to the anchoring bias – a good way to torpedo your long term investment returns.

Anchoring bias is a behavioral finance term, much like mental accounting, which I wrote about earlier. It describes a specific type of irrational investor behavior.

How it works

Anchoring bias happens all the time. Here is an example:

You buy a stock at $30 per share. It drops to $22 per share over the next year. You decide to hold on. Your plan is to sell if it gets back to $30. You are now anchored to the $30 per share number.

When to cut loose?

Facebook (FB) provides a good example. It went public at $38 per share. I am sure thousands of people are waiting for it to get back to that number to get out of the stock. Why not get out now? Or why not just wait until $37 instead of $38? They are “anchored” to the $38 per share number because that’s where they bought it.

But isn’t it smart to hold on if you are down? Isn’t it “rational” to wait to get back to even before selling?

Not at all. The number to which an investor is “anchored” often has no rational significance. Is the company worth that much based on its future cash flows? Does its book value, earnings or dividends somehow support the sell target? No! The number to which the investor is anchored is only significant in that it is the number where they bought the stock. Other than this personal relationship, the number has no other significance – and if that is the case, then why is the investor mentally clinging to this anchor as a sell target?

When to hold on?

In some circumstances it makes sense to hold on. For example, it makes sense to hold on for the long, long term if you are buying a well diversified basket of stocks, like we recommend. If it is down, you wait for it to come back up. If it is up, you let it ride further. Either way, you hold on for the long term. That isn’t anchoring. That is long term portfolio theory. Don’t get the two confused.

 Photo by Stew Dean