In my last article I wrote about what is Anchoring Bias and we also saw few examples of anchoring Bias. Now this month I would like to throw some light on how it affects our investment decisions and How to get out of Anchoring Bias?
How Anchoring Bias affects our investment decisions?
Anchoring is basically a state of mind where we give more importance to first piece of information or some numbers or events while making our decisions. Here we get anchored to that information, number or event while taking any decisions. This happens very frequently in Investment decisions. Let me first discuss few real life examples of anchoring bias affecting our investment decisions and then we will see how to take investment decision without Anchoring effect.
- Anchoring to purchase price of loss making company: Suppose you have bought shares of two companies, company A and company B.See following table and tell me if you are in need of money and you have to sell any one of these two companies, which one you will sell? Company A or B? Most of the investors will sell company A. Do you know the reason why? Because company B is below its purchase price so they are anchored to Rs. 60 the purchase price. Here decision of selling company A is result of company B operating below purchase price and anchoring effect to its purchase price. Ideally speaking in this case it looks that company A is doing good and is a fundamentally strong company so one should hold it whereas it seems that company B is not a good company and one should sell it and book the loss. This type of cases regularly come to me where investors have bought some shares and they have gone below purchase price but when I tell them to sell it they tell me they will sell it when it reaches to their purchase price. So actually they are anchored to that purchase price which in this example in case of company B is Rs. 60. Here investors need to understand that the price at which they bought this company is not at all important now , what is important is that fundamentally whether this company will do good in future or not? , is it at fair price currently or not? But while taking decision of selling company B they are anchored to purchase price.
- Share Purchase decisions based on higher share prices in Past: Recently I met with an investor who showed me his share portfolio. There were almost 56 company shares in that portfolio and most of them were in loss. When I started discussing about the reason for buying those company shares individually one by one, most of the times his answer was that “this company’s shares were quoting at Rs. 100 per share around a year back and then it has fallen to Rs. 50 so I thought it will come back to Rs. 100 and I will double my money. So I bought it.” So he was anchored to higher price which he saw. The buying decision was the result of anchoring effect to higher price and not the analysis of the company’s fundamental factors.
- Anchoring to Past Returns experiences: Between 2003 to 2007 there was bull market in equity and sensex went up from 3000 to 21000 and if you look in to data of good equity mutual funds they were giving returns in the range of 25% to 30% p.a. after that markets collapsed in 2008 and started improving in 2009 and by 2012 investors were again getting around 15% p.a.. Returns of 15% p.a. are also good returns for an equity investment. But those investors who invested between 2003 to 2007 and earned high returns felt that these returns are very low and kept changing their funds and financial advisor believing that they are not doing good job and actually earned less returns due to changing funds and advisors. This happens because while analysing performance of their funds they were anchored to their higher returns experience and so believed that these funds are giving less returns. Due to anchoring bias they could not analyze the current situation of economy and see that overall returns in equity market have gone down. This resulted in wrong reactions of changing funds and advisors.
- Anchoring to Events: Many times clients who had invested at the time Harshad Mehta Scam are reluctant in investing their money in equity by saying that I made losses in the times of Harshad Mehta scam- this scam took place in 1992 and that was the time many of the investors first time invested in stock market in India and were left out with huge losses which they could not forget. This is example of people getting anchored to events which occur in their investing life at initial stages. They are anchored to these bad experiences and not able to leave them behind and take their investment decisions by doing analysis of current economic fundamental in neutral and rational manner.
- Anchoring to lower Indices Number: My father many times tells me that in my times Sensex was around 2000 and today it is 28000 so it is very costly. I try to explain him many times that over last 20-25 years economy, consumption, turnover and corporate profits have grown sharply and multiplied many times in India and so Sensex reaching 28k is justified but he is not able to digest this logic and make fresh investment in equity shares because he is anchored to 2000 level of Sensex. This is a very common argument that I receive from many senior clients.
- Subscribing IPO based on belief that they are cheap: Most of equity market investors believe that IPOs (initial purchase offers of shares) are offered at cheap prices and will give more return. Here people get anchored to some of the past IPOs history where those companies turned to be very successful and investors multiplied their money very fast. But as a matter of fact IPOs are generally offered at significant premium and most of the IPOs don’t yield good returns. So due to anchoring to few past successful IPos and mindset that IPos are cheaper investors buy IPO.
- Anchoring to lower purchase price mindset of NFO : When it comes to mutual funds, many investors have tendency to purchase new funds which are launched at Rs. 10 because they believe that this is starting price so they feel it is relatively cheaper and will not fall below this price. So here they are anchored to lower price of the new fund and decision of investing in that fund was a result of that anchoring effect to lower price and not analysis of the characteristics of the fund. But actually when a new fund with Nav of Rs. 10 or an old fund with higher NAV invests in stock market they get shares at same price. Ideally old funds are better as they have more experience and have seen different market cycles.
How to get out of the anchoring affect?
If you will see in all above cases, decisions taken by investors are not based on fair and logical analysis but these decisions are result of anchoring to some numbers, past events or past experiences. While taking any decisions we should be rational and think on the reasoning of those decisions in a logical way and should not get anchored to some number, event or experience. As far as possible our decision should be based on predefined logical process, like in above case of buying shares, decision of buying shares should be based on process driven fundamental analysis of companies business and not based on their historical prices. So to conclude with be careful while taking decisions and try to be more logical and analytical.