The next decision-making error is a phenomenon known as anchoring, and this often clouds people’s judgment when it comes to investment decisions.
So what is anchoring exactly? As mentioned, humans use mental shortcuts to assist in decision-making and information processing. Anchoring is one such shortcut. The human brain selects an initial reference point and bases decisions around that point. As an example, when a salesperson sets an initial price for an item, they usually set it higher than the real value for the item in an effort to extract the highest possible price by setting an anchor in the consumer’s mind. During the bargaining process, the initial asking price (or anchor) serves to set the initial tone for what the item might be worth, and any final price is set with the initial anchor in mind.
For example, if a home is offered by an agent at $1m, even though the seller wants $800,000, the $1m sets an anchor in the minds of prospective buyers. And so if a buyer ends up purchasing the property for $900,000, they feel that they have made a wise purchase as they compare the result to the anchor (initial reference point), even though that figure ($1m) was somewhat arbitrary and probably unrelated to the value of the property.
To demonstrate how this mental shortcut can be a pitfall to good investing, consider an investor who sees a stock fall substantially from its highs and goes to purchase in an effort to do a bit of bottom-fishing or bargain hunting. Multiplex (MXG) would be a good real-life example to use here. Say an investor witnessed the stock drop from $5.75 in February 2005 to $4.50 in March 2005, one month later. That investor uses the initial reference point (the anchor), being the February price of $5.75, as evidence of value, and so in comparison, the March price of $4.50 seems very cheap. Of course, the stock went on to plumb lows of $2.89 after that. Clearly, whilst $4.50 was much lower than the February price of $5.75, it was not good value and so the anchor of $5.75 served only to misguide investors.
Hopefully, this example demonstrates the dangers of placing emphasis on the anchor. It is natural for the brain to select an anchor (as a shortcut) around which to make decisions, but don’t let anchors influence your decision-making when it comes to investing. This shortcut may have evolved as it is useful in other areas of your life, but when it comes to investing, it often leads to poor decision-making.