This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 18 June 2016.
In an ideal, theoretical world, human beings are all rational, clear-thinking individuals, able to make perfect decisions and choices every time. The reality however, is very different. We’re an emotional bunch, prone to letting our fears, aspirations and biases override our common-sense. Our emotional biases also unfortunately impact our investment decision-making. One of the most common biases is that of ‘anchoring’. Anchoring is the tendency to erroneously assign too much importance to irrelevant information. For example, you might buy shares in a company for $5. Bad news causes the share price to fall, but you refuse to sell, stating that you’re going to wait until it gets back to $5 before selling. The $5 level is irrelevant, it just happened to be the price at which you bought the shares. It has no relevance at all in regards to the current value of the investment. If you had bought in at $4.50 you would probably use that as your trigger level. Neither figure carries any importance except that which you assign them in your own mind. You’ve become irrationally anchored (or fixated) on a random price and this anchoring is affecting your decision-making. If it’s a poor investment it should be sold, rather than hoping it’ll get back to your break-even.
The problems associated with anchoring are not restricted to just the stock market. Most people have had a conversation with someone who is selling their home who says something along the lines of “…well I paid $400,000 three years ago, so if I can get that back I’ll be happy…” Again, that’s anchoring. The price you paid for your home however many years ago has no bearing on its value today. You should assess the value of your home (or shares) on its merits, with no consideration of what you paid for it. Of course, because we are emotional beings, that’s hard to do. Too easily we entangle our decisions with our emotions. Avoiding the problem of anchoring can be difficult; it’s impossible to just ‘forget’ what you paid for your house or shares. One way is to get someone else to make the decision for you, someone who is not subject to the same anchoring bias. Someone who doesn’t care about the price you paid is more likely to make an objective decision on the value of your shares (or house). And a mountain of academic research has shown that objective decision-making, at least in an investment context, is far better than an emotion-driven process. So next time you need to make such a decision, let go of your anchor or ask somebody to do it for you.