Letting go of anchoring bias

Information overload is a common problem in equity markets. Analysts, journalists, corporate honchos vie for the investor's attention with a torrent of numbers and news.

The investor often responds by latching to various tidbits of information from these sound bites. It may be a production target, sales projection or comments by analysts on how the share price is at a multi-year low and is attractive.

Economists and psychologists being what they are have given this behaviour a name: anchoring. It's about an investor's tendency to let one piece of information, such as a buy price, target price or sales projection, outweigh other relevant information or developments when it comes to making an investment decision.

DROPPING ANCHOR

Let us say you bought into company X at Rs 200 with the rationale that the valuations look good given the superior margins, great visibility for sales and a wonderful regulatory environment.

The investment rationale holds up nicely until a new piece of regulation is proposed.

This new rule limits the company's ability to price its wares and this affects your rationale to buy into this company. The stock drops off a cliff to Rs 150.

You now think that the stock was a buy at Rs 200, so it must clearly be a buy right now. That may or may not be true, but what is important is that you sit down with someone who understands the regulation and figure out how this new information affects the company. How does it change the way the company operates and makes money? This should be the key determinant of why you decide to buy or sell your shares.

As Investment writer Mr Benjamin Graham put it, Mr Market does not know you or how much you paid for a stock.

So, why do you put so much emphasis on the price when what matters is why you paid that price?

Much like the buy price, analyst projections for earnings per share or a company's target output provide a false sense of security for the price paid.

They are expectations which are often subject to wild revisions based on what happens in the big bad world of volatile currencies, irate governments and unpredictable monsoons.

RAISE THE ANCHORS

How, then, do you prepare for the unknown?

How do you prevent yourself from acting on a completely misplaced sense of security?

An extreme case in the fight against anchoring is of the famous mutual fund manager, Mr John Templeton, who would research and then commit himself to buying shares at a predetermined price to avoid the pessimism of bear markets from clouding his judgement.

Surgeon-novelist Mr Atul Gawande in his book, Checklist Manifesto, provides an easy solution. When you decide to buy or sell an investment product why not write down 5-10 succinct reasons for doing so?

When the time comes to sell or buy again, you have a list of reasons to weigh your decision against.

While this may not guarantee a great result, it minimises the chances of glossing over what you know with certainty.

Better yet, when something dramatic happens, you get a chance to re-weigh the assumptions backing why your investment made sense in the first place.

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