Behavioural finance: Anchoring

Imagine you are bartering for a rug and the stall-holder starts with a ridiculously high price. You know you must respond with a lower price but your brain is still making a sensible adjustment from the crazy price.

The stall-holder hopes you won’t make a sufficient correction so that you pay too much. It’s an everyday example of a common decision-making frailty: our tendency to anchor to numbers in the face of uncertainty.

With investing, numbers to anchor to are ubiquitous: this is why it is one of the most common cognitive traps for investors. Forecasting, in particular, allows the anchoring bias to run free.

Imagine two reports that forecast gold prices a year from now. Report A suggests a doubling of the price while report B suggests a tripling. Investors who read report B might be reluctant to sell after a doubling of their investment – they are anchored to the idea of a tripling. What if the price falls? Investors risk hanging onto a losing investment by clinging to anchors.

Much of the harm of anchoring is exacerbated by other behavioural biases such as hindsight, overconfidence and an attachment to “narrative fallacy” – a story that justifies a forecast. The problem is the story may not play out – and the story itself is typically a device for understanding a chaotic world.

Anchoring in forecasting is a best-guess exercise and investment professionals are aware of the pitfalls. More dangerous is the subconscious anchoring to irrelevant numbers that derails many investors. Why does the price an investment is bought at act as an anchor on future decisions? Most worrying is the fact that people still anchor to information they know is irrelevant.

Many investors are guilty of latching onto market prices as anchors. This is dangerous as prices may prove to be overvalued or undervalued. They are simply the latest estimation of value and may not reflect the real value of a company.

So how should investors deal with anchoring when the tendency to anchor is overwhelming?

James Montier, one of the leading authors on behavioural investing, has a suggestion. It is that investors should anchor to something with predictive power namely, income streams such as dividends.

While earnings can be manipulated by accounting treatments, dividends cannot. In this way, they provide a barometer of a company’s financial health. Studies suggest that bubbles are more likely to appear in stocks when investors lack dividends as an anchor.

Dividends and dividend yields provide a way for investors to understand price relative to value. Equity-income investing has always been seen as appealing to the patient investor. Now it has behavioural appeal to those who want to overcome common investing vulnerabilities.