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Keeping an eye out for anchoring bias

As human beings we suffer from numerous cognitive biases, things that make us think in certain ways that are for the most part not helpful.

One that hits investors especially hard is the anchoring bias.

Anchoring bias is the result of us as humans relying too heavily on the first piece of information that we get when making a decision – in other words, the first impression.

This can happen when you meet a new person or when you first see a house you’re potentially looking to buy.

If the first impression of the house is negative it will take a lot to convince you to buy, whereas if it’s positive, the agent will hardly have to do any work as you’ll be hooked.

The problem is that information we receive after that first impression may be critically important, but we dismiss it as less important.

When investing, that anchoring typically involves the price of a share; either the price paid or a price we remember.

Often, the price we remember is when we first saw the stock.

For example, I remember putting an offer in to buy Naspers* at R248.50. The offer was R250 and I never got the stock.

Now, with Naspers at around R2 000, I still have that R248.50 imprinted in my mind and struggle to move on from it.

It’s not just that I missed a great investment, it is also that I still think Naspers is a buy at R248.50 and struggle to adjust the new valuation of some R2 000.

The other side of this is when a stock has fallen and we are anchored on the higher price.

Here Kumba is an example. A reader emailed me to say that they’d been watching Kumba slide from around R500, so surely now it is a buy at around R130?

The issue is that the R500 price point is totally meaningless. It is a random fact that the reader remembers the R500, what matters now is the prospects for Kumba going forward.

Further, we tend to believe that a stock will get back to the price we remember, so if R500 is the ‘target’ it must be a steal at R130.

This is just not reality and many stocks have never recovered to previous levels. A most notable example here is African Bank, which is now bankrupt.

A bigger example is the Nikkei 225. The price falls, and we remember the old price, so we are convinced things are cheap.

The Nikkei 225 has not yet recovered to the highs of the late 1980s when it peaked at over 40 000. These days, it is half that value.

Another anchor, and perhaps the most dangerous to investors, is the price we pay for a share.

The price we paid is no longer of any importance once we’ve bought the share, yet we remember it. The problem is especially bad if the stock has fallen.

Rather than looking at the stock with fresh eyes and asking ourselves what we should do, we remember the price we paid and want the stock to rise to that level again so we can exit without a loss.

The reality is that the price we paid is now gone and while it was important when we were buying, once we’ve bought the price we paid is meaningless.

What now matters is if the stock is still worth holding or even adding to.

So as an investor, you need to watch out for anchoring bias in your thinking and when you spot it (and you will at times, nobody is immune), recognise it for what it is and remember the current price is what matters.

What you paid or previous highs and lows does not matter to the valuation today.

*Finweek is a publication of Media24, which is a subsidiary of Naspers.

This is an article that originally appeared in the 14 May 2015 edition of finweek. Buy and download the magazine here.

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