Anchoring

We all have a lot of trouble buying stocks that have gone up a lot and selling stocks that have gone down a lot. If that’s you then I regret to inform you that you are being affected by a well-established financial concept that only affects soft brained investors. It is called “Anchoring”. Anchoring, also known as a ‘focusing bias’, is the use of a reference point against which to judge value.

You hear the issue every day in a broking office, it’s when someone says “I can’t buy that because the share price is up XYZ%” or “You can’t sell that the price is down XYZ%”. An even more soft brained development on the theme is when you find yourself saying “It’s down XYZ% so it’s cheap” or “It’s up XYZ% so it’s expensive”.

But making money in shares is all about where the share price is going. In that equation, where the share price has been is pretty much irrelevant and the fact that we don’t buy or sell a stock because it is up X percent or down X percent, because of where the share price ‘was’, is unscientific. What you paid for a stock, what price it was in the past, in fact, any reference to the share price history, ignores the only relevant consideration which is what the share price is going to do tomorrow. BHP five years ago was priced on a different set of facts to BHP now, so what relevance is that old high or old low. It’s irrelevant.

Despite that it is common practice to reference how much a stock has moved from the lowest low or highest high and it is commonplace to take those past prices (laughably - the extreme highs or lows) as an anchor point from which to judge the current price as being expensive or cheap based on how far it is up or down since then.

But past prices are simply a statement of where a price was. The more important consideration is what the company is worth now coupled with an understanding that the market's appreciation of what the company was worth at some point in the past has almost certainly changed. As soon as the value of a company changes, which arguably it does every day, you have to move your thinking along.

If your decision making starts with a reference point from the past (It’s up XYZ% from the low”) you have proven yourself a bit amateur. To make a stock judgement past prices are the most unscientific of starting points.

Another amateur manifestation of anchoring is buying stocks because they have fallen a lot. This is technically wrong to do (you should sell stocks going down not buy them). Buying bombed-out stocks (catching the knife) because they have fallen a lot, ignores the fact that the market’s assessment of the company's value has changed, a lot, for the worse, so the ‘attraction’ of a big fall is irrelevant.

The other very widespread use of anchoring is when traders use their purchase price as a reference point. “I’ll sell it if it goes up 10%” or “I’ll sell if it goes below my purchase price”. All very nice but not rational, although, in its defence, anything, even unscientific anchoring, is better than nothing when it comes to having some trading discipline.

An extension of anchoring is ‘lazy jargon’. Saying that a stock is “cheap” or “undervalued” because it has fallen a lot. Or “expensive” or overvalued” if it’s gone up a lot. A stock can only be valued with reference to what it is worth, not with reference to what the share price used to be.

The best way to avoid anchoring is to forget the past price as a reference point and simply assess ‘cheap or expensive’ on some other criteria. PE history perhaps, or price relative to an intrinsic value calculation would be more useful.

Meanwhile you can amuse yourself by listening out for anyone, you perhaps, making comments or decisions on the basis that a stock is up X% or down X% because your sole focus should be whether a stock is going up or not. The fact that it’s gone up or not, that, is irrelevant.

Anchoring - Another reason humans aren't wired to trade successfully.