Drop anchoring to improve returns
Anchoring bias is bad for your investment health. Here's how to manage it.
In an experiment in 2006, German psychologists Birte English, Thomas Mussweiler and Fritx Stack asked a group of experienced prosecutors and judges to decide on appropriate prison sentences for some fictional criminal cases.
Before they delivered their verdicts, however, they were asked to roll a pair of dice. Unbeknownst to the participants, the dice were loaded so that every roll resulted in either a 3 or a 9. Following the roll, judges were asked to stipulate a prison sentence.
The results were troubling.
On average, those who rolled a 9 gave out sentences that were 60% longer than those who had rolled a 3. The difference between a 5 month and an 8 month stint in the slammer determined by the totally unrelated number thrown.
This is known as the 'anchoring effect', and there are countless other examples that confirm its existence.
Plenty of them come from the field of investing.
It's why people hang on to stocks that have fallen in the hope they'll get back to break even.
It's why people wait, before buying, for a stock to get back to the price where they first started researching it.
It's why people will wait for an arbitrary 10% correction in the market before investing in a managed fund, even though they didn't invest back when the market was trading at that exact price 6 months ago.
It's why people are slow to adjust their earnings forecasts when the facts change.
As with most human biases it's probably not possible to eradicate anchoring completely, but you'll be able to manage it better if you're aware of it.
If you're out hiking and you see a rock tumbling down a hill towards you, the natural tendency is to look down and cover your head. But I've watched enough Bear Grylls in my time to know that the best bet is actually to keep your eyes fixed on the rock so you can get out of the way.
So next time you research a stock, note the numbers you see along the way and ask yourself if they're influencing your thinking.
Be wary of relying too heavily on individual earnings forecasts. Try to avoid looking at the current share price and historical price charts, because your value of the stock is likely to gravitate towards those numbers.
Besides cash, even the figures on a balance sheet need to be read with some care as they're all open to different values depending on accounting choices made by management.
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