If stock valuation is not right, it may be time to weigh anchor

Sharemarket investors and boat owners have something in common: over time, each becomes accustomed to anchoring.

For boat owners, anchoring is something to be mastered. For investors, it's a common psychological bias that can cost us many thousands of dollars.

Anchoring is the tendency to focus on and attach ourselves to irrelevant information when making decisions.

If you've ever said to yourself, "I'll just wait until the prices get back to $1.20 and then I'll sell", or "the stock has doubled so it's too expensive" or "it's fallen 70 per cent so it must be cheap", then you've been a victim of anchoring.

The price you pay for a stock is always irrelevant to any decision to sell (we'll get to what you should focus on shortly).

We anchor to prices because it has relevance to us. Over time, your investment results will depend on the prices you buy and sell at. But these prices are irrelevant to each individual decision to sell.

In Behavioural Investing, James Montier explained anchoring like this: "When faced with uncertainty, we have a tendency to grab on to the irrelevant as a crutch." Montier makes two important points. First, we often don't realise we're anchoring at all. Second, anchoring occurs because investing is an inherently uncertain and complex activity.

Human beings are attracted to certainty and precision. We therefore become fixated on numbers such as purchase prices, price-earnings ratios (PERs), profit forecasts, or precise discounted cash flow valuations.

These numbers help paint a picture but an emphasis on too few of them oversimplifies the story. So what should you focus on?

The simple answer is the company's value. Value investors analyse a company's underlying business carefully. This analysis should lead to a valuation range (rather than just one number), which can then be compared with the stock price.

Over time, you'll want to update this range with new information that comes to light (trying to avoid anchoring to your initial valuation). Here's an example.

You recently bought XYZ company at $47 a share. Since then, the share price has fallen to $40 and you're unsure whether to buy more or sell. How do you decide what to focus on?

There are three scenarios. Only your valuation range estimate differs.

What action you should take depends on comparing two variables - the current price and your valuation range.

In scenario A, the share price is considerably above the valuation range. Here, it makes sense to sell the stock whatever you paid. If you anchor on your purchase price instead of the valuation, you are ignoring the fact that you own an overpriced stock.

In Scenario B, the stock is trading in the middle of your valuation range, so it would be worth continuing to "Hold".

Scenario C reflects what you as an investor are trying to do regularly. Here, you correctly bought the stock at $47, well below its valuation range of $60 to $70. If the valuation remains unchanged, the decline in the stock to $40 shouldn't worry you. Indeed, your margin of safety has increased, so you should consider buying more.

In all cases the purchase price remains the same but each scenario leads to a different decision, based not on price but your estimate of value.

It's not easy determining a company's intrinsic value but ignoring it in favour of something irrelevant - such as purchase price - is a mistake.

Effort spent worrying about price movements is better used to develop your analytical toolkit so you can make a more accurate assessment of intrinsic value.

Next time you catch yourself focused on purchase price - or the loss it implies - take time out to reassess the stock's valuation.

Anchoring might keep the boat enthusiast's pride and joy firmly in place, but anchoring on a share price could sink your portfolio.

This article contains general investment advice only (under AFSL 282288). Nathan Bell is the research director at Intelligent Investor Share Advisor, shares. intelligentinvestor.com.au.