This week we are going to examine what is known as Anchoring and Adjustment Bias.
Source: Towergate Insurance
When negotiating the price of an item we are often swayed when we feel we’re getting a bargain. Make sure to consider if the price is actually reasonable for that item or if you have perceived the value based against the original price.
According to Michael M. Pompian, author of Behavioral Finance and Wealth Management
“Investors exhibiting this bias are often influenced by purchase “points”—or arbitrary price levels or price indexes—and tend to cling to these numbers when facing questions like “Should I buy or sell this security?” or “Is the market overvalued or undervalued right now?”
Pompian goes on to say how Anchoring and adjustment bias can cause investor mistakes:
Investors tend to make general market forecasts that are too close to current levels. For example, if the Dow Jones Industrial Average (DJIA) is at 10,500, investors are likely to forecast the index in a way narrower than what might be suggested by historical fluctuation. For example, an investor subject to anchoring might forecast the DJIA to fall between 10,000 and 11,000 at year-end, versus making an absolute estimate based on historical standard deviation (rational) analysis.
Investors (and securities analysts) tend to stick too closely to their original estimates when new information is learned about a company. For example, if an investor determines that next year's earnings estimate is $2 per share and the company subsequently falters, the investor may not readjust the $2 figure enough to reflect the change because he or she is “anchored” to the $2 figure. This is not limited to downside adjustments—the same phenomenon occurs when companies have upside surprises. (At the end of the chapter, we will review a behaviorally based investment strategy leveraging this concept that has proven to be effective at selecting investments.)
Investors tend to make a forecast of the percentage that a particular asset class might rise or fall based on the current level of returns. For example, if the DJIA returned 10 percent last year, investors will be anchored on this number when making a forecast about next year.
Investors can become anchored on the economic states of certain countries or companies. For example, in the 1980s, Japan was an economic powerhouse, and many investors believed that they would remain so for decades. Unfortunately for some, Japan stagnated for years after the late 1980s. Similarly, IBM was a bellwether stock for decades. Some investors became anchored to the idea that IBM would always be a bellwether. Unfortunately for some, IBM did not last as a bellwether stock.
Let us help you eliminate this bias. Professional advisors with disciplined systems of investing tailored specifically to your investment goals will allow you to overcome many of the obstacles inherent in our very nature. At DWAM, we can help.