The topic of this episode is a psychological heuristic, or mental short-cut, called anchoring. Have you ever been sucked into buying an item at a store – let’s say a t-shirt – because a sign showed it was selling for 50% off regular price? The initial price was $30 and it’s being offered for $15. The $30 regular price we’re referencing may or may not be real, but no matter – we have anchored on it without any effort to validate the number, and jumped to the conclusion that $15 is a great deal.
Here’s another example. Was Gandhi older or younger than 140 years old when he died? Now how old do you think he was when he died? Take a guess and make a mental note of it. A survey was done in 1997 based on this question. Half of the participants were first asked if Gandhi was older or younger than 9 years old when he died, and the other half was asked if he was younger or older than 140. Here are the results: Participants in the high anchor condition guessed on average he was 67 years old, whereas those in the low anchor condition guessed he was 50 years old when he died.
As explained by Investopedia, anchoring is the “subconscious use of irrelevant information, such as the purchase price of a security, as a fixed reference point (or anchor) for making subsequent decisions about that security.” Why should we as investors care about this topic? The answer is that making missteps as a result of a lack of awareness of anchoring is more deadly than meets the eye. I believe it could make an enormous difference over one’s investment lifetime if self-awareness can mean avoiding errors. Anchoring is consciously used as a tactic in pricing and negotiations of all sorts. I’d like to point out that there is nothing malicious about using anchoring as a technique in negotiation and it is in fact common practice, backed by logic: Why would you, as buyer, start negotiating at what you think is fair value, and position yourself from the get-go for the final price to land only above that?
The key difference for participants in stock markets is that there is no conscious effort by a counterparty to use anchoring to influence us – nor is there the opportunity for us to actively profit from it from a negotiation standpoint. After all, the buyers that buy from us and the sellers that sell to us on any given transaction are anonymous. More than anything, anchoring for a common stock investor is a risk that can lead to suboptimal trading decisions, specifically in selling too soon after a share price rises, being compelled to buy more of security after a price drop, or the error of omission: dismissing a potentially wonderful investment opportunity because a share price recently increase a lot without a thorough consideration of the bigger picture.
Understanding the anchoring effect makes us realize that we may not be as in control of our decision-making as we believe. That may be a disturbing thought to many. Nobel Prize winner Daniel Kahneman dedicated a chapter in his book, Thinking Fast and Slow, to the topic of anchors.
In it, he describes the results of several striking studies of the anchoring effect at work. One of the key findings was that any number you are asked to consider as a possible solution to an estimated problem will induce a subconscious anchoring effect, regardless of whether that number is absurd or uninformative. This phenomena is not just a theoretical, academic curiosity, but something that has been measured through experiments.
Take for example the experiment done at the San Francisco Exploratorium. One set of participants was first asked the question, “Is the height of the tallest redwood more or less than 1200 feet?” This was followed by asking them for their guess about the height of the tallest redwood. The next group went through the same exercise, except they were given a low anchor of 180 feet before being asked to estimate the height of the tallest redwood. It shouldn’t be surprising that the two groups produced very different average estimates – 844 feet for the first group that was given the 1200 feet anchor, and 282 feet for the group given the 180 feet anchor. Clearly, the participants were influenced subconsciously by whatever number they were first exposed to.
Another somewhat similar experiment involving a non-profit fundraising situation showed that the use of anchoring can make a significant impact. Participants were asked to make an annual contribution to save seabirds from offshore oil spills. When no anchor was mentioned, the average donation was $64. For those who were first asked if they were willing to pay $5, the average was $20. And lastly, the group that was first anchored with $400, averaged a much higher $143 donation. The difference of 615% was directly attributable to the low vs. high anchors put into participants’ minds.
However, the power of these random anchors can have worrisome effects. The last example from Kahneman’s chapter I’d like to highlight is the experiment wherein German judges with more than 15 yrs of experience had to decide the sentence for a hypothetical woman caught shoplifting. A pair of dice first had to be rolled – these dice were rigged so that every roll resulted in either a 3 or a 9. On average, those who rolled a 9 sentenced her to 8 months versus 5 months for those who rolled a 3.
Anchors are so powerful that in all decision-making situations, regardless of training, experience and education – they are likely to influence us. Investing in common stocks is no exception, and again – although there is no effort by the counterparty to manipulate us when we are buying or selling on the open market – we need to be onguard for making unforced errors.
Now onto the most common error for long-term investors in public equities arising from anchoring: being triggered to transact after a significant gain or loss. Listeners will have to do some soul-searching here – we will go over a few techniques later but upfront I will suggest that the key way to combat self-inflicted anchoring is to consciously slow down decision-making. Allowing more time to pass before making a decision promotes the weighing of more information and points of view.
Mistake #1: Knee-jerk selling after a quick rise in a stock’s price. There’s the saying ‘No one ever went broke taking a profit’. It may seem like a rational decision to pare back on a holding that recently spiked, and you may be ‘right’ if the stock makes a round trip soon after. But despite the outcome validating your decision, it is a mistake if you sold only because it shot up, fearing a round trip. For example, is the price still far below your estimate of intrinsic value and more undervalued relative to other holdings in your portfolio? It’s very possible. After all, if your estimation of intrinsic value was $100 for a stock purchased at $50, a sudden 30% jump off your cost to $65 would mean there is still 54% remaining upside to your target price. How does that compare to other portfolio holdings? If it is now inferior on a relative basis, perhaps it makes sense to switch some or all of the capital to other holdings.
Another reason to second-guess your intuition to sell after a quick run-up in price is to remind yourself whether the holding in question is a long-term compounder. This is a subjective and qualitative question, but where does this company lie in the spectrum of business and management quality relative to your other holdings? If it is a lower quality company bought primarily because of undervaluation, that implies you have less confidence in the long-term future and therefore it may make sense to be more willing to part with some or all of your holding after a big price increase.
Where I see it as most acceptable to trim a position is under risk management and portfolio optimization considerations, when the parameters were pre-defined and therefore the decision was not based on impulse. Professional investors often set absolute maximum percentage limits on holdings, and if a threshold is breached because a stock shoots up, this triggers a sell. Cash is then generated that can be rotated into holdings that have yet to work out… this can in fact boost the overall returns of the portfolio while limiting single-stock exposure. But tax consequences and trading commissions are frictional costs that must always be carefully weighed. It is important to note here that while a quick increase in share price did lead to a sell, the key reason was risk management and NOT anchoring on a lower price.
The second common error related to anchoring is a key one for value investors who pride themselves on buying low, and that is the dismissal of investment ideas that recently shot up in price because we anchor on the percentage increase or lower price. This is the exact opposite of the $15 t-shirt that was supposedly marked down from $30 – thus triggering us to buy. If a stock price quickly goes up by 20% – we anchor on the lower price or the striking percentage increase and stop buying or perhaps even sell, despite having an estimate of intrinsic value that means the now-higher price makes still make economic sense.
Here’s a personal example I talk about often: A friend told me about a stock called Constellation Software back in 2011. He had just attended its annual general meeting and told me over lunch how excited he was about it. Then I looked at the price and saw that it had run up 80% in fairly short order. And I immediately dismissed looking into further because I was fixating on the fact that the stock had doubled over two years, thinking I had missed the opportunity. Here we are now in 2023 and the price is more than 27x higher than when my friend had first told me about the name. At its $70 price at the time in 2011, Constellation Software was trading only 11.5x FCF for that year – cheap considering per-share cash flow was compounding at over 20%. Now we can say hindsight is 20-20, but the truth is that anchoring led me to the wrong decision, and very costly from an opportunity cost perspective.
Anchoring can also influence us when estimating fair value for a company. Warren Buffett has said before that he comes up with an estimate of a company’s value per share first, and then looks at the price. One can deduce that it must be because he doesn’t want to be influenced and anchored by the stock price during the evaluation process. For example, if I use a DCF model to estimate a value for Apple and arrive at a value of $120, I might then look at the price of $143 and conclude that it is overvalued. My valuation could end up being straight-up wrong for any of reasons – and the stock takes off from here. But even so, in that hypothetical example, I came up with a value based on my evaluation of the company’s fundamentals and projections of cash flow. If instead, I were to focus on the $143 price, there’s a good chance when laying out the valuation in my spreadsheet that my assumptions will subconsciously bend such that my estimate of intrinsic value will come closer to the $143, or higher if I had a desire to own the stock.
Finally, how can we protect ourselves from mistakes related to anchoring? I have two main suggestions in no particular order:
- First, use your investment checklist to every trade. This will encourage you to take more time for every decision and discourage impulsive trading.
- Next, create and follow your own rules regarding maximum position sizes. This forces diversification and actually has nothing to do with preventing mistakes related to anchoring, but it limits the exposure of your portfolio or net worth to the impact of any single idea. For example, if a stock goes up 50% and the holding is now beyond the maximum weighting that you laid your own ground rules for not exceeding, then a sale here would be done out of adherence to risk management parameters. Or if the price increased to a point where the margin of safety is gone, and at the same time other holdings in your portfolio are deemed to be far more undervalued, there is an argument for selling some or all and recycling those funds in candidates that are now far more compelling on a relative basis.
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