What makes a good investor?
Legendary investors such as Warren Buffett or Peter Lynch may be the first person who comes to your mind. It is hard to argue against their success, but I wonder how many retail investors (even the professional ones) have the same discipline, focus and patience to stay the course through the roller coaster ride of the stock market.
People are not born to do long-term investment because our genes are coded to pay attention to noises, we react and flee when any sign of danger arises.
If this is the only bad trait that we were born with, it is not so bad. The problem is that we have a lot of behaviour bias that will lead us making illogical investment decisions and losing money. In the investment world, It is a widely studied topic called behavioral finance. Today I am going to talk about one of the most prominent one, “anchoring”.
What Is “Anchoring”?
“Anchoring” refers to the tendency that you attach your thoughts to a reference point, even though it may have no logical relevance to the decision at hand.
To explain this, let me tell you a story of mine.
When I was 22, I went on a holiday with my friends in Macau. Considering myself a “rational person”, I decided to try my luck at the Casino on the last day of the trip.
I did not go unprepared. I chose a simple game with a high probability of winning game, “Sic Bo”.
The rule was simple, three dices were rolled, and you bet “Big” or “Small”. If the sum of the three dices was between 4 to 10 and you bet “Small” for $100, you get back $200. If the total number is between 11 to 17 and you bet “Big” for $100, you will also get back $200.
There were other variations of the game, but I chose to just play this Big/Small game. Because Mathematically, I had a winning chance is 48.61% (see the explanation here). Since I had HKD700 left, I decided to bet only HKD100 every time.
My plan was that since I have nearly a 50% chance to win, I can play many hands and end up winning a bit or losing a bit. And I could walk away with all the thrills and fun without losing my pants. Good plan, right?
Here we go,
I bet “Small”, it opened “Big”;
I bet “Small” again, it opened “Big” again;
I bet “Small” again, it opened “Big” again;
I bet “Small” again, it opened “Big” again;
Then I started to think…
If you were me, what would you bet next? Big or Small?
I know, you must be thinking the same as me. After all, what is the chance for it to have 5 straight “Big”?
And yes, I bet “Small” with HKD300 and lost my last dollar on that day.
It was only after I calmed down that I realized that each result was an “Independent Event”.
Mathematically, the past 4 straight “Big” had no effect to the result of the 5th bet. The chance for the 5th result to be “Big” was still around 50%!
Well, it may sound counterintuitive, it is why the Casino like to show the past results prominently. By anchoring you to a situation like that (5 Big in a row), It gives you an illusion and overconfidence that you next bet has a better chance (betting more aggressively).
Anchoring Amplifies When Money Is at Stake
We anchor all the time because we need some reference point.
When you change jobs, do you want to be paid higher than your current salary? When you sell your house, do you want to sell for more than the price you paid?
But if you realize “anchoring” does more harm than good when it comes to money, you need to be very careful. Many people make big money mistakes based on irrelevant figures and statistics.
Let me share you another story.
When I was at a Karaoke party not long ago, a friend suddenly shouted, “Is it real? did Facebook’ stock just drop 20%? It is a golden opportunity to buy this stock now!”
The other friend agreed, “Yes, it was much higher price yesterday, I am in too”.
Within a few minutes, both bought the shares using their mobile app. I was shocked to see how fast the decisions were made based on the reason that the price was “discounted”.
In the next few days, I received a few calls from my clients asking if they should buy Facebook stocks because it is “ON SALE”!
I am not here to debate whether Facebook is a good stock to buy, but the market spoke for itself. As you can see from the chart below, Facebook’s stock price continued dropping after that.
In today’s age, information and technologies are so widely available, what separates a successful investor and a failed one is not trading tactics or insider information, but your ability to master our own emotional bias.
In the above example, my friends made the buying decision because they were “anchored” to the stock price of Facebook on the previous day. When it was opened at $174+ on the next day, it looked “dirt cheap” and undervalued.
The truth is, $217.50 on July 26 2018, was a past price and when the new price opened with 20% down, it reflected the fundamental has changed. You cannot use the past information to make an accurate assessment for the future. When you bought the share believing the stock is still worth $217.50, you became the victims of the anchoring phenomenon.
Anchoring Bias Leads You Overpay for Your Property
When you buy a property, your negotiation price is commonly “anchored” by the asking price from the seller or the last transacted price of a similar property.
In 2012, many HDB buyers used to pay a ridiculous Cash-Over-Valuation price (COV) because it was asked at that time. To me, it was totally irrational and the asking price should not be your “anchor” in negotiation (read this article for my explanation). True enough, COV faded off in 2013 and it was eventually removed by the government in 2014.
In my article about property investment, I have explained that the successful property investors don’t pay the “ask price”. They have a weighing machine themselves and they will only make a deal if their price is reached, which I call “Insane discount”.
Anchoring Bias Makes You Keep Your Losing Investments
Anchoring not only affects your buying decision but your selling decision as well.
It is very natural for people to use a purchase price as a reference point to make a future decision.
If you bought a stock for $100, and it suddenly dropped to $80. What would you do? Would you be able to accept the loss or wait and hope the stock price “comes back”?
If you think about it rationally, the price you purchased the stock has no influence over the future stock price. Your decision to buy, hold or sell the stock at a loss should be based on the assessment of the market outlook and specific challenge which company is facing.
You may have some gold bars or gold coin in your house, and you may have bought in 2011 when the gold price was at a record high, and you are not alone. However, if you anchor at the purchase price and wait for the recovery, you are still losing nearly 40% after 7 years holding the gold.
How to Minimize the Damage That Anchoring Does to You
You can’t avoid anchoring, it is in your genes. And it is not all bad. By anchoring our current status and always working towards a better self is how human get evolved to a modern world today.
But when it comes to personal investment, you need to engage in the rigorous critical thinking process. It’s best to be careful about the “fact” you utilize to evaluate, always fathom what you believe true may not be true. You need a systematic way to evaluate each scenario derive the truest picture of the investment landscape at hand.
Seeking a Second Opinion
In Ray Dalio’s famous book the Principles, he urges people to seek thoughtful disagreements. If you have a portfolio, show it to an investment professional who does not have the same emotional attachment to your investment choices.
It may be hard to admit that you are wrong by yourself, but having such an evaluation may unveil the blind spot that you never realize by yourself.
As a licensed investment adviser, I offer a non-obligatory meeting to review your existing stock investment portfolio. If you want a second opinion of the stocks and funds that you are holding, simply submit your request using the form below.