The stall-holder hopes you won’t make a sufficient correction so that you pay too much. It’s an everyday example of a common decision-making frailty: our tendency to anchor to numbers in the face of uncertainty.

With investing, numbers to anchor to are ubiquitous: this is why it is one of the most common cognitive traps for investors. Forecasting, in particular, allows the anchoring bias to run free.

Imagine two reports that forecasts gold prices a year from now. Report A suggests a doubling of the price while report B suggests a tripling. Investors who read report B might be reluctant to sell after a doubling of their investment – they are anchored to the idea of a tripling. What if the gold price falls? Investors risk hanging onto a losing investment by clinging to anchors.

Much of the harm of anchoring is exacerbated by other behavioural biases such as hindsight, overconfidence and an attachment to “narrative fallacy” – a story that justifies a forecast. The problem is the story may not play out – and the story itself is typically a device for understanding a chaotic world.

Anchoring in forecasting is a best-guess exercise and investment professionals are aware of the pitfalls.

More dangerous is the subconscious anchoring to irrelevant numbers that derails many investors. Why does the price an investment is bought at act as an anchor on future decisions? Most worrying is the fact that anchoring happens when people know they are using irrelevant information.

Many investors are guilty of latching onto market prices as anchors. This is dangerous as prices may prove to be overvalued or undervalued. They are simply the latest estimation of value and may not reflect the real value of a company.

So how should investors deal with anchoring when the tendency to anchor is overwhelming?
James Montier, one of the leading authors on behavioural investing, has a suggestion. It is that investors should anchor to something with predictive power, namely income streams such as dividends.

While earnings can be manipulated by accounting treatments, dividends cannot. In this way, they provide a barometer of a company’s financial health. Studies suggest that bubbles are more likely to appear in stocks when investors lack dividends as an anchor.

Dividends and dividend yields provide a way for investors to understand price relative to value. Equityincome investing has always been seen as appealing to the patient investor. Now it has behavioural appeal to those who want to overcome common investing vulnerabilities.

In order to ensure you are making a measured and tactical investment choice, always speak with your financial planner when making investment decisions.

Source: Fidelity Worldwide Investments
 

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Investor confidence, emotions and psychology play a powerful role in driving share markets. Past experiences, pre-conceived ideas and fear of regret are just a few of the biases and behaviours that can lead investors to make emotional and often irrational decisions.

Identifying and understanding these behaviours can help investors avoid many investment traps and lead to better investment outcomes.

Fear of Regret – Afraid to make the wrong decision

The key underlying premise for this behaviour is an investor’s fear of incurring losses. This fear of making the wrong decision often means investors don’t assess risk correctly – they tend to over-emphasise risk which can actually lead to wrong decisions or inertia in making a decision.  Investors need to ask themselves which risk is greater: the risk of making a investment decision that could lose them money; or the risk of missing out on an opportunity that could make them money? Studies have shown that people tend to have the highest level of regret for actions they didn’t take rather than actions they did take.1

An example of regret is an investor’s difficulty in selling a losing stock. The feeling of regret is strongest when the loss is crystallised – until that point the investor holds out hope of the stock returning to its ‘former glory’ and avoids generating feelings of regret by holding onto it.  Another aspect to this is that if the investor made the original investment decisions by themselves, the feeling of regret is much greater than if they were following someone’s advice. It’s not so much about the pain of making a loss, but rather the pain of being responsible for making the decision. This could explain why investors sometimes find it easier to outsource their investment decisions (ie to a financial advisor) – apart from needing professional investment advice, it also means some of the burden of making decisions is shared.

The fear of regret often leads to inertia in making investment decisions. In some respects this could be one of the reasons why around 80% of Australians have remained in the ‘default’ fund in their superannuation plan, despite encouragement from the heavily publicised ‘Super Choice’ campaigns. As the default option tends to be a balanced fund, this can mean a significantly lower superannuation payout on retirement than if invested in a higher growth option over an individual’s full working life. Not making a choice therefore potentially exposes investors to greater risk – they are swapping the risk of losing money with the risk of not having enough money in retirement.  Given many super investors have a very long time horizon the latter risk is likely to be significantly higher than the former.

Emotion and the human psyche are indeed powerful forces, often leading investors to make irrational decisions, or sometimes even worse, not making any decisions – both of which can be detrimental to the long-term performance of an investor’s investment portfolio. By removing these emotions and psychological behaviours from the decision making process, investors are in a better position to make logical and rational decisions. Seeking professional investment advice from a financial advisor, taking a long-term view, constructing portfolios based on an investor’s risk/return profile and investing with professional fund managers are steps an investor can take to help them achieve this.

Source: Tyndall Investments

1 Source: Hersh Shefrin (2002) “Beyond Greed and Fear, Understanding Behavioral Finance and the Psychology of Investing”, Oxford University Press

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