How Anchoring Can Destroy Your Returns

September 6, 2017

How Anchoring Can Destroy Your Returns

  • You might not be aware of it, but you are under the influence of many things. After all, you are human.
  • Anchoring is really terrible as it makes you take profits too soon and keep your losers. We’ll discuss the post earnings drift effect, loss aversion, and the breakeven issue.
  • Additionally, we’ll discuss 5 ways to eliminate anchoring from your decision making process.

Introduction

We’re under the influence of the behavioral finance anchoring concept when we take a past reference point for determining whether a stock is a buy or not. For example, the chart for Hudbay Minerals (NYSE: HBM), a copper miner that I recommended to subscribers of Global Growth Stocks in May, shows that the stock is very volatile. Those who didn’t buy in May at prices around $4.75 in the hope for even lower prices, anchoring their entry point to a past number which in this case was the $3.7 bottom reached in October 2016, missed out on a beautiful run-up.


Figure 1: HBM stock price movement in the last 2 years. Source: Yahoo Finance.



The issue is that anchoring takes the focus off of fundamentals and onto the stock price which isn’t a reliable indicator but has an extremely strong psychological effect on us. In the case of HBM, the low price in May was because of missed estimates due to some unplanned maintenance and low copper prices. It was clear that both were just temporary issues as copper prices spiked and HBM quickly solved the engine failures it experienced.

In today’s article, we’ll discuss what anchoring is and how to avoid it blocking us from buying a great company or, even worse, make us hang on to a losing stock.

Behavioral Finance: Anchoring

Anchoring was first described by Kahneman and Tversky in 1974 when, in an experiment, they asked people to multiply the last 3 digits of their phone number by 1,000 (example 543*1,000 = 543,000). Subsequently they asked participants to estimate house prices and results clearly indicated that participants, unaware of the fact, anchored their house price estimation to the phone number factor despite the 10-minute factual house market presentation given prior to the experiment.

Anchoring doesn’t effect us just in the stock market, it also impacts us in many other activities ranging from buying a house, where the first home shown to us by the agent effects our opinion on the following (beware, the agent knows that), consumer good purchases where you are enticed to buy 18 bars of something, or the attractiveness of interest rates (if you bought a house in the 1980s all the current interest rates are extremely low, but if you are a millennial, the current 30 year fixed rate seems very expensive when compared to the variable rate).

A great example of retailers taking advantage of our anchoring unawareness are sales. For example, practically every advertisement you see from IKEA is one where the prices have been lowered. IKEA knows 99% of the population is unaware that they are under the influence of anchoring.


Figure 2: IKEA’s front page advert. Source: IKEA.

Anchoring & The Stock Market

We fall under the influence of anchoring when we make investment decisions based on past price levels and not on fundamentals, as was the case for Hudbay. I also often hear investors say that they’ve missed the boat on a stock because I recommended it at let’s say $15, and the stock is now at $17 while my fundamental target is at $30. Yes, the returns will be lower when the starting point is $17, but they would still be great.

Apart from when to buy a stock, investors tend be even more under the influence of anchoring when it comes to selling. It’s widely known that one of the reasons why most investors underperform the market is that they hold on to their losers and quickly sell their winners.

Investors usually tend toward at least getting even if a stock doesn’t move as hoped for. This is mostly an ego factor, selling would be admitting we were wrong and thus would be painful. Unfortunately, many investors stick to their holdings despite deteriorating fundamentals which leads to terrible returns.

The third example of the anchoring effect is the post earnings drift effect. When a company announces earnings, better or worse than expected, which usually isn’t immediately reflected by the stock price, but the stock price slowly drifts toward the new balance value.

A great example of the post earnings drift effect is Teva Pharmaceuticals (NYSE: TEVA) which recently announced a loss, cut its dividend, and lowered future guidance, all of which were unexpected by the market. The stock price didn’t immediately fall from $32 to the current $16 level, but it slowly drifted toward the current price over a month, and those that were quick in selling could have closed their position at prices above $25, which is where the stock was trading immediately after the announcement.


Figure 3: TEVA’s stock price in the last few months – slowly drifted from $26 to $16. Source: Yahoo Finance.

How To Eliminate Anchoring From Your Decision-Making Process

The first thing to do is to focus on fundamentals and to clearly understand what your investment goals are. This will allow you to quickly make rational decisions based on actual earnings and not on temporary market sentiment. Focusing on long term earnings trends will enable you to buy more when the prices fall while the fundamentals improve, and sell when the prices improve but the fundamentals don’t.

The second thing to focus on is absolute performance and not relative or market performance. For example, if the current 10-year Treasury offers a yield of 2.16%, many would see stocks that offer a 4% earnings yield as cheap. However, both returns will be extremely disappointing in the long term, especially if we see inflation or higher interest rates in the future. If you focus on finding a 10% yearly return, you will find it and perhaps even at lower risk.

The third thing to do is to invest for the long term and not allow temporary market swings to influence your decisions. Jumping from hot sector to hot sector or replacing your underperforming fund with the outperforming one without any fundamental reason is what  has led the average investor to achieve returns of 2.3% over the last 20 years.



Try to eliminate the influence of the media. What the media does for the most part is to describe past trends that have no influence on the future. Therefore, 98% of daily stock market moves are mostly noise, as are 76% of monthly stock market moves and 46% of yearly moves. Only 10-year stock market moves are primarily influenced by fundamentals.

The fifth thing to do is to not use the high watermark. For example, most investors would be much happier if their portfolio went directly from $200,000 to $240,000 in a year than they would be if their portfolio went first to $300,000 and then dropped to $260,000, even if the latter case is the better outcome. The high watermark is irrelevant, but has a very strong impact on us as we secretly hope that the stock price will return to the prior higher levels.

Conclusion

Anchoring is your worst enemy when it comes to investing. The issue is that many don’t even recognize it as we are mostly unaware of it given that it is wired into our neuro system.

To summarize, the answer is that the best way to invest is to be rational and not allow market trends, no matter how exciting they might be, to influence your investing decisions. By doing so, you’ll definitely reach satisfying long term returns with low risk.