Anchoring Bias: Don’t get stuck in the past.

on Tuesday, 15 July 2014. Posted in , ,
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If you were asked to guess whether South Korea’s population was greater or lesser than 15 million, what would you guess?  Research shows that suggesting a number influences the guess.  Not just in that scenario, but in many, a known or stated number will influence your choice, even if there is no rational reason why it should.  Consider these scenarios that are pretty common.

  • Decision-MakingI don’t want to sell at a loss.  I’ll just wait since I’m still down 5%, so I’ll wait as long as it takes.
  • My neighbor got $400,000 USD for his house last year, so I should be able to sell for that.
  • I invested $300,000 USD in my business and I should get at least that much back.
  • I don’t want to invest in the United States.  The economy has tanked there since 2008 so I want to avoid it.

None of these statements are rational, but that actually very very common.  Consider what happens in each scenario.

1. Why waiting for a profit isn’t always a good idea.

This isn’t a hint about taking a loss on a share for tax reasons, although that sometimes isn’t a terrible idea.  The true question is “Given what I know today, what shares have the best outlook?”  You should then hold these shares.  Consider the following.  You own Qantas which you bought at $2.50 in 2010.  It is now $1.30 ish.  Should you hold on?

Many people don’t like to sell at a loss.  It is like admitting failure.

Even though Qantas isn’t profitable this year, and hasn’t been for a few years, and is getting worse, many people will keep waiting.  Another option would be to buy a growing company like Starbucks that could grow its share price by 20% per year for a few years.  Many will keep Qantas and ignore the growing company.  But what if Qantas never recovers and goes broke?  What if it takes 20 years to recover your money?  Is that a good growth rate on your money?

Action: When reviewing your portfolio, consider, would I buy this share at its price today, knowing what I know now?  Would I consider another share more attractive?  Use these questions to base your decision, without any reference to where you bought it at.  It feels wrong, but it is the logical decision making process.

2. Does beating your neighbor really matter?

I’ve seen many clients like this too.  They want to achieve “their number”, often based on previous market conditions and remain wedded to this number despite problems it causes them.  I have a client who has a property in Shanghai right now, that wants to sell but hasn’t because the figure is still 1 million below what the property was worth 18 months ago.  This is despite the fact that they will put the whole family on hold from leaving Shanghai, and have missed out on some good stock market returns over the last 18 months.  Because they haven’t hit their number, they continue to wait.

3. Sunk cost doesn’t matter.  Value today matters.

Small business owners and indeed some property investors find this difficult to get over.  The business is worth a combination of the assets and the cash-flow that it brings in.  It is no use to the next owner if you invested your life savings into a money losing business.

4. Are you still in fear like it is the crisis of 2008?

newtons_cradleA common bias is to be anchored to a past reality.  Every day we see investors online in the US still afraid of a housing bust.  There are still people still convinced that the US economy is still in recession.  The fact is that US economy has slowly rebounded, paid off a lot of debts and deleveraged.  Unemployment is now at 6.1%, which is a long way down from the heights of 10% in 2009 and it continues to improve.  Yes many have left the workforce, and nirvana is still out of reach, but the current trends are in the right direction.  Are your assumptions on performing and underperforming economies still rooted in the past?

This advice is useful, not just for investing, but also for negotiating and sales.  A starting price often influences the outcome considerably.  Be sure to position it in your favor, just be careful of overdoing it.

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