Anchoring and adjustment bias. The price at which you bought a stock is irrelevant.
Anchoring and adjustment bias is the tendency to interpret new information based on an arbitrary anchor and adjust opinions accordingly. It can lead to forecasts too close to current levels and inflexible views. Discover whether you are prone to an anchoring and adjustment bias and how it affects your investment decisions with PRAAMS BehaviouRisk.
Behavioural science. What is anchoring and adjustment bias?
This is a behavioural pattern whereby one interprets new information using an arbitrary anchor and then adjusts one’s new opinion relative to this anchor. For example, if an investor buys a stock at $100 a share, the answer to whether the market is now overvalued or undervalued will be relative to this random $100 anchor. Another example may be an investor that bought the stock at $100, saw it rise to $150 and then decline to $120. If this investor is heavily exposed to anchoring and adjustment bias, he will judge the success of this investment decision relative to the latest $150 anchor. In his view, the investment ‘lost’ 20%, creating a need for an investment to grow back to $150 to break even. The rational, smart investor interprets new information without relation to existing anchors. In answering whether to hold or sell this position, the rational investor will base his decision on the company’s and market’s fundamentals and risk factors, and the $100 and $150 will play no role.
Anchoring and adjustment bias is a cognitive bias, i.e., a mistake in decision-making. These biases can be effectively corrected with education.
What are the consequences and portfolio risks?
Individual investors exposed to anchoring and adjustment bias tend to have forecasts too close to current levels. For example, if the stock price is $100 today and such an investor were asked to estimate the price in one year, the most likely answer would be in the $90–110 range or the $70–130 range if the stock’s historical volatility were higher. Secondly, the same individual investor would forecast future returns based on the most recent risk-return relationship. For example, if the stock grew 15% last year, the investor would expect it to grow around 15% next year. The third implication is that individual investors become stuck firmly with their prior risk and return analysis of a company. Consider a company that has been a leader in its market segment for several years. This anchor of being a leader would be reproduced in such an investor’s mind for many years, even though the market situation may have changed by that time. Another implication is doggedly sticking to original forecasts. Imagine an investor forecasting that the stock price would increase from $100 to $140 in a year based on a 40% net profit growth forecast. If the company reports 20% or 80% net profit growth in six months, this investor will unlikely adjust his forecast significantly down or up.
What can I do to make my portfolio optimal?
The first sensible step in overcoming anchoring and adjustment bias is to recognise it. It is a cognitive bias and can be eradicated by education and controlling your analytical process. A tendency to cling to any anchors, be they figures, levels, or beliefs, is a red flag for this bias, and noticing such red flags and reconsidering your asset allocation strategies will add value to your analysis. The same is valid when you read financial media, analysts’ research, or other opinions on a market or a company. If you spot anchoring in their logic, perhaps it is not a good idea to rely on their conclusions.
