Anchoring bias TOPIC: RISK
You may imagine a ship on a shore which has been anchored. The ship is unable to sail and seek new lands because of the existing bondage.
Anchoring is a behavioural finance bias since market participants, such as financial analysts or investors, are not perfectly rational but rather psychologically influenced and emotion driven. Therefore, biases can occur and are often assumed to impact on market outcomes and returns.
If you are anchoring yourself, you are looking only the surface of a very broad area. This concept is widely used because we want quick solutions to complex problems without having to go through the trouble of acquiring knowledge, but in this process, we reduce our chances of running unbiased valuations.
In the context of investing, market participants with anchoring bias tend to hold investments that have lost value because they have anchored their fair value estimate to the original price rather than to fundamentals. As a result, they assume greater risk by holding the investment in the hope the security will return to its purchase price.
More precisely, traders are typically anchored to the price at which they bought a security. For example, if a trader bought stock ABC for €100, then she will be psychologically fixated on that price for a sale or further purchases of the same stock, regardless of ABC's actual value, based on an assessment of relevant factors affecting it.
Given this, it is clear that an anchoring bias leads to make an incorrect financial decision, such as buying an undervalued investment or selling an overvalued investment, causing market participants to reject rational decisions.
If we don’t withdraw the anchor, the ship will never be able to sail to seek newer lands. The same applies to our investment philosophy. You will never know the power of investments, returns and compounding unless you allow yourself to be free of the bondages that you have created for yourself.
It is for this reason that Warren Buffett ignores the share price and instead looks purely at the fundamentals. He simply doesn’t want to be influenced by it and instead comes to an unbiased valuation.
What is a viable solution? Market participants can mitigate anchoring bias by identifying the factors behind the anchor and replacing suppositions with quantifiable data. Thus, the decision-making in the investment process should rely on comprehensive research and assessment of factors affecting markets or a security's price.
Image source: Everett/Rex shutterstock
Autore: Beatrisa Pucalev, Asset Management, Risk Junior Associate