Biases In Investing: Anchors and Priming
Good (or: great) investors must master several disciplines. We should have knowledge about the economy, about accounting, and expertise about the industry a company is operating in. And we also should know about psychology as investing has to do a lot with psychology. In this article (and some following articles) I will look at several biases and how these biases are affecting investment decisions and could lead to huge and costly mistakes. We will start with a bias that is called “anchoring” but first provide a short description what a bias actually is.
Definition Bias
(If you are already familiar with biases, you can skip this section)
In general, a bias is the tendency towards a certain perspective (or a certain opinion or belief). And while biases can be conscious and unconscious, they are always influencing the way someone thinks or behaves. Especially in decision-making and problem-solving these biases can be a huge problem and a threat as they might lead to terrible decisions — for example terrible investment decisions.
We can try to group these biases in different categories, including:
Cognitive biases, which arise from the way our brains process information — like the confirmation bias (the tendency to look for and rather accept information that is in line with our already existing beliefs).
Memory biases affect the way we remember information and examples include the hindsight bias (the believe that events were more probably after they occurred).
Decision-making biases, which affect the way we make decisions — like the sunk-cost fallacy (when we continue to invest in a project because we already invested money before although further investments don’t make sense).
Anchoring
One of the biases that can be a huge problem in investing is anchoring, which means you take a number that often doesn’t make any sense and start thinking from that number. As long as we are talking about assets (or stocks, to be more precise), anchoring is occurring whenever a “price” is set somehow for an asset. And this is the case whenever “price information” about the stock is available.
A price is available from the stock market itself, which is providing price information every second. But a price information is also available from analysts and bloggers writing about the assets. Another price information is the purchasing price of an asset, which can be an important information for the person who bought the asset. All these price information can be anchor — and very seldom these price information as “useful information” or in line with the intrinsic value of a stock.
Anchoring by Price Targets
One form of anchoring in financial markets is the setting of price targets by contributors on sites like Seeking Alpha or Motley Fool or by financial analysts. In this case, many different people set a price target for a stock and every single price target can be an anchor.
When different analysts have wildly different price targets, anchoring effects probably won’t occur (or won’t be strong) as it is not clear to which price target we are anchored. But when different analysts have very similar price targets, anchoring can and will occur. And it is problematic when these price targets are completely unrealistic (and not in line with the intrinsic value of a stock). This usually happens in the months (and years) before an asset bubble peaks: Many analysts are setting extremely high price targets, in most cases above the current stock price, which is already above the intrinsic value.
While I don’t want to insinuate that analysts or contributors are manipulating the market, I also won’t be so naïve to assume that analysts and bloggers don’t have their own interest (the reason why disclosures are important). Different players in the market have different interest. And when somebody is purposefully setting an unrealistic price target this is called priming.
And when many analysts assume that stock X should be worth twice the current price, it is hard to assume the stock is overvalued. When the stock is trading for $100, and everybody claims it should be worth $200 a form of anchoring is occurring at the price of $200. And even when you assume the stock is overvalued, you might set your price target rather at $150 than at $120 or $100 or $80 (as such low price targets seem absurd when comparing them to $200).
Anchoring by Price Action
Aside from the price targets set by financial bloggers or analysts, the market itself is also setting a price. The stock is always trading for a specific price and therefore a form of anchoring is occurring. And especially when a stock is trading for an extremely overvalued or undervalued price for a long time, the anchoring is especially strong. It is difficult to claim that the market is getting it wrong for several years. This is once again what is occurring before bubbles — stock prices have been increasing for years and claiming that these prices are not reflective of the fundamental businesses for several years is difficult.
Anchoring by Buying (or Selling)
And a third form of anchoring is occurring when you are buying (or: selling) a certain asset. The price you purchased a stock for is a kind of anchoring for yourself and you most likely assume price levels lower than your own purchase price as too low and not reasonable. This is how resistance and support levels are created. When many market participants are buying (or selling) stocks at a certain price, they will buy or sell at that price level in the future (or have a stop loss at that price level) and this can lead to a turnaround in the stock price (and is creating a strong support or resistance level).
When I purchase a stock for a certain price, I am setting an anchor for myself. This price level for which I bought a stock (it might also happen when selling, but more when buying) is suddenly getting important for me although the market might not care for that price level at all.
Fight Anchoring and Priming
Of course, you can fight anchoring and priming in investing by doing your own research. The more you know about a company and the stock price, the better you can fight priming. It is especially important to look at the fundamental business and calculate an intrinsic value for yourself. Also look at historic valuation levels (for the entire stock market, for sectors and for individual companies) to determine if the current valuation levels make sense. And here several simple valuation metrics come into play — like the CAPE ratio — which might give us some strong hints where we are in the cycle.
While it is often difficult to fight biases, Kahneman is giving some advice how to fight anchoring:
In general, a strategy of deliberately “thinking the opposite” may be a good defense against anchoring effects, because it negates the biased recruitment of thoughts that produces these effects (Kahneman 2011, p. 127).
And I know it is almost impossible when participating in the stock market, but to avoid priming it would be best to start your own research on a company without reading any articles, any statement from analysts and also not knowing what the stock is trading for. And only after determining an intrinsic value for yourself, you look at the current stock prices and what other blogger and analysts are writing.
Kahneman is also offering another defense strategy in negotiations: To walk away when an offer is ridiculously low (or high). And you should do the same in the stock market: Walk away from completely overpriced stocks and look somewhere else. Because a risk of priming is also that we see a previously completely overpriced stock suddenly as acceptable priced after a 20% or 30% decline — as we are anchored to extremely high prices.
Conclusion
While anchoring is certainly a problem for investors, there are ways to at least minimize the negative effects. And a first important step is already achieved when being self-aware of the problem and acknowledge that biases — including anchoring — play a huge role in investing. When realizing that every price information is influencing us a little bit and that priming may occur by analysts and commentators (and in case of Tesla even crowds of fans on Twitter) we already made a big step.
Literature:
Kahneman, Daniel (2011): Thinking, Fast and Slow. Penguin Random House UK
Note: Article was originally published on Medium in March 2023 (can be found here).