The price you pay for faulty anchoring

Retail investors lose huge sums of money by using irrelevant data

January 26, 2020 10:51 pm | Updated 10:51 pm IST

Wheel Of Fortune. Gamble chance leisure. Colorful gambling wheel. Jackpot prize concept background. Vector Illustration

Wheel Of Fortune. Gamble chance leisure. Colorful gambling wheel. Jackpot prize concept background. Vector Illustration

In his bestselling book on behavioural psychology — Thinking, fast and slow — Nobel laureate Daniel Kahneman explains the ‘anchoring effect’ through an experiment he once conducted using a wheel of fortune.

Mr. Kahneman rigged the wheel which was marked from 0 to 100 so that it would stop only at 10 or 65. He asked participants to spin the wheel and then asked them to note down the number where the wheel stopped, which was, of course, either 10 or 65. He then asked them two totally unrelated questions — is the percentage of African nations among UN members larger or smaller than the number you just noted down?

The second question was — what is your best guess of the percentage of African nations in the UN?

The spin of a wheel of fortune cannot possibly yield any useful information on the two questions listed above and the participants ought to have ignored the wheel. Yet, their responses on the estimate were 25% and 45%.

This is called ‘anchoring effect’ where people refer to an initial clue or one piece of information (10 or 65 as above) to arrive at value, even though it may result in an error in judgment. Mr. Kahneman described it thus — it occurs when people consider a particular value for an unknown quantity before estimating that quantity.

This bias is very prevalent in our day-to-day interaction like in shopping at roadside shops where we bargain. We typically start the bargaining from the price which the vendor quoted irrespective of whether it is right or wrong.

You can see the same effect in discount sales as well, where we end up either buying lot of stuff or stuff which we don’t actually need. We get anchored to the list price and the steep discount as a cue for making the decision to buy. Much of the value that the customer perceives is based on anchoring of discount price rather than estimating actual value of the goods to take an informed decision.

This anchoring bias is prevalent in investing too. One of the basic traits of good investing is to buy stocks, bonds or any asset at a cheaper than intrinsic value.

Investors often take this message very seriously and display their behaviour very consistently on the wrong side. They end up taking the wrong initial clue, which is stock price or asset price, as the value instead of looking at fundamental data like earnings, book value or cash per share.

Consider this example from the real world:

Shares of Dewan Housing Finance Corporation Ltd. (DHFL) share were priced at ₹590 each in January 2018 — retail shareholders held 8.4% of the firm’s equity. During the course of the year, business fundamentals deteriorated , resulting in a sharp drop in price from ₹590 to around ₹300 — a 50% fall from the previous peak.

Instead of taking stock of the new reality, investors rushed to buy more of the stock misled by the 50% fall from peak price — after all, isn’t buying stock cheaper a great idea? And so, the retail shareholding doubled from 8% to 16%. Investors probably felt the worst was over.

But the stock continued to fall. In the next three months ending (April 2019) the stock fell from ₹300 to ₹150, another 50% fall from recent peak and 70% drop from all-time high.

Though both the peak prices are irrelevant data for assessing the current investment value, investors were misled and bought more shares taking the share of total retail investment in the stock to 21%. But the stock fell even more... to ₹30 in the next six months. The market price of ₹30 represented a fall of 80% from recent six-month high, or 90% from a 12-month high or 95% from the all-time high. Thanks to their sustained buying, the share of retail investors in DHFL jumped to 32% in the same period.

Losing wealth

Retail investors had lost huge wealth, time and energy by wrongly anchoring the previous high price and continuously buying the stock which was rapidly losing value.

They failed to appreciate that any decision to buy a stock should be based on the intrinsic value of the company and that the previously traded price is a completely irrelevant data point in the decision-making process. They were misled because they “anchored” their expectations to an irrelevant number.

Similar anchoring bias is also displayed during the selling of a stock. Investors are often reluctant to sell a stock which is below their purchase price (wrong anchor) and willing to wait endlessly rather than assessing the current intrinsic value of the stock to make the right decision.

How to reduce or avoid the effect of wrong anchoring bias in decision making?

1. Decisions to invest in or divest from a stock should be based on valuation of the stock using parameters such as EPS, cash flow per share, book value etc. rather than on the price.

2. The ‘previous high’ price is an irrelevant data point for considering today’s purchase or sell decision. The current price is the new reality and the investor should consider all the relevant information to take appropriate action.

3. Investors have also lost opportunities by not buying stocks where business is flourishing which is reflected in a high stock price stating the price has already moved from, for example, from ₹100 to ₹150.

The question that investors should ask is: is the price of ₹150 still attractive to make a required rate of return. If the value is still there, then it makes sense to invest and not be bothered about the lowest price point, which, in this case is ₹100.

4. Finally, avoid herd behaviour like the black sheep in the flock. Knowing the risk — the sheep started moving in the opposite direction to survive.

(The author is an investment analyst)

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