By Vipul Prasad
The importance of behavioural finance in fundamental investment process is difficult to overstate. Anchoring bias is a common behavioural heuristic that often prompts investors to make poor decisions. Seeds of this bias are sown when someone assumes certain value for an unknown quantity before attempting to estimate that quantity. Bad outcomes follow when one is unable to dissociate from this assumed value even after receiving new information. Here are some examples of anchoring bias in investments:
False assumption of missed opportunity: Let’s say an investor considers buying a stock at Rs 100. While he is analysing the stock, it rises to Rs 115. The analysis concludes that the stock can rise to Rs 170-180 over the required investment horizon of, say, two years. In another scenario, the investor rejects the stock at Rs 100, but after some time—when the stock has appreciated to Rs 115—he takes a relook and realises that the stock has massive upside.
In both these situations, the investor may now, owing to anchoring bias, wait for the stock to slip closer to Rs 100 before he buys it. The problem is he anchored himself to the price of Rs 100 where the stock was when he considered it initially. But instead of getting hooked on to the notional loss (of Rs 15, i.e. the difference between purchase price and the price when he first considered the stock), the investor should focus on the potential upside (48-57% as per his analysis, i.e. the difference between purchase price and fair value of the stock).
Chasing up a stock: This situation is commonly encountered after a false assumption of missed opportunity. Let’s say, as earlier, after rejecting the stock at Rs 115, the investor again investigates the stock at Rs 130 after coming to know that his friend bought the stock at Rs 115. Due to the ‘missed opportunity’ syndrome, he again refrains from buying the stock. He has been monitoring it closely and thinks of buying it at Rs 150, but concludes, to an extent rightly, there is not much upside left. He has also been checking his friend’s hefty returns.
Eventually, in a dash of greed and recklessness, he buys the stock at Rs 165, even though his dispassionate analysis pegged the potential upside at a maximum of 5-10%. But anchored to his friend’s stock return so far, of about 45%, he somehow flexed his valuation model to suggest, mistakenly, further upside potential of 30-40%. The mistake here was he got hinged to past stock returns, and to the profit made by his friend. Had he maintained focus on his real anchor in the circumstances, he would have done the stock’s fair value calculation to estimate his future return.
Buying after a steep fall, or at 52 weeks low: Often, one buys a stock just because it has fallen by 20-30% in, say, last 3-6 months. Here the investor is incorrectly anchoring to the stock price prior to the decline, or to the price trend in the last 52 weeks. In reality, the stock may have reasons to fall more incrementally and the right anchor should be the fair value of the stock. For example, in a majority of the stocks in India that fell by 20-30% in 1HCY2018, actually fell further in the second half of the year, too—many are still languishing not too far from their lows, with dim future prospects. Indeed, there is no harm in starting with such filters, but it is extremely important to analyse the stock fundamentally from all aspects before making an investment decision.
Waiting for break-even: There are occasions where even if one does not like a stock any more, one continues to hold it, hoping for a break-even. Since the investor had purchased the stock at Rs 100, he is essentially unwilling to sell it at Rs 97—even if he does not like it. If he were to behave rationally here, he would compare the current stock price of Rs 97 to the fair value (say, at Rs 75) and not to the purchase price (Rs 100).
Selling too early: If an investor purchased a stock at Rs 100 with an assessment it would grow to Rs 200 over three years, he should not sell it after appreciation of 33% in one year—unless there is a change in the stock thesis and hence in incremental upside expectation. Else, the investor would wrongly take the purchase price as the anchor, whereas he should concentrate on the fair value. If the stock looks good to hit Rs 200 over next two years, even after it has reached Rs 133 in the first year, it will be a poor move to sell it there.
While there is no clear-cut formula to overcome anchoring bias in investments, awareness and assessment can act as the first line of defence. It is important to disconnect oneself from past stock trends, or purchase price, and instead to focus on fundamentals and on the stock’s fair value. The key is to spot our brain’s urge to take the easy and fast route in such situations, leading to mistakes. To avoid falling victim to anchoring bias in investments, one needs to use templates from the past as well as from other disciplines and assess multiple options before arriving at an investment decision.
The author is founder & CEO, Magadh Capital