Anchoring is a psychological term used to describe the tendency we humans have to anchor our thoughts to a reference point, even though that reference point often doesn’t have any meaning and shouldn’t be used to guide decisions. This is an important topic to understand in investing, particularly in volatile assets like stocks or real estate. It’s another area where knowledge of how our mind works helps us fight our natural but irrational instincts. It will help make you a better investor.
Let’s start with an example that many people can easily relate to: your own home (for the many of you that don’t have a house, bear with me…I think you’ll find its still a good example to use). Let’s say you purchase your home for $180,000. Over the next several years, the home appreciates to an estimated value of $210,000. Great!! You’re feeling pretty good about your house investment.
You’ve largely forgotten about the money you spent on home improvements, utility bills, mortgage loan interest, and property taxes. You’ve also forgotten that inflation happened over this time. You just see an apparent increase in wealth of $30,000. At the same time, you’ve appreciated the improvements you’ve made, especially those you did yourself. The perfect shade of gray you picked out for you bedroom and the beautiful new rose bushes you planted out front. And you’ve built some really nice memories living in the house over the years. Maybe you started a family and watched your kids grow from babies to big kids. Maybe you’ve hosted a lot of out-of-town visitors and had a lot of fun.
A few years later, you’re forced to relocate for your job. You know the housing market hasn’t been great lately but you’re shocked when your real estate agent estimates your home value at $170,000! In fact, you’re angry and depressed about the whole thing. How is this possible? You paid $180,000 for the house many years ago! And not too long ago, it was worth $210,000! And you made the house so nice (in your opinion) with all those improvement projects since you bought it!
So what is driving your emotions here? It’s the differences in the numbers and your expectations associated with these numbers. Does it really matter that you paid $180,000 for your house? Or that it once reached a value of $210,000? Or that it’s now valued at $170,000? Well, it matters to your pocketbook but it doesn’t matter at all to the market. It’s important to remember that ALL of these prices are correct. Or I should say were correct at the time they were defined. The value is set by the market based on many factors. Supply and demand plays the biggest role but there are many other factors as well. This is why real estate agents constantly look for comparable home prices (similar features, size, location) and then make minor adjustments up or down based on the particular home. This is the best way to set an objective market price. For the current market price, any past prices don’t matter. What you paid to buy the house doesn’t matter at all. The market value is the market value at that point in time.
For the homeowner, despite understanding this, it’s difficult not to have strong feelings about these numbers. In particular, selling a home for less than you paid for it is particularly painful to people (this is loss-aversion at work in addition to anchoring). This is why you see home sales decline when home values drop. In some cases, owners are underwater (the owe more on their home than it’s worth) and would have financial difficulty in selling at a loss. In many other cases, it’s psychological. Homeowners hate the idea of selling for less than they paid so much that they are willing to stay in that house until the market goes back up. Even if that takes many years (and the increase is only due to inflation meaning there was no real gain in value). And even if it prevents them from whatever opportunity was driving them to move in the first place.
Unfortunately I can relate to this example.
The first home I owned, I eventually sold for slightly above what I paid. This made me feel good although if I factored in the costs of improvements we had made, it was still a slight loss. Even knowing this, I felt good that the selling price was above what I paid even though is was a very small amount above. If it had been even a little below what I had paid, I would have felt much worse, even if the difference was only a few thousand dollars. I can’t control these thoughts any more than anyone else, but understanding and noticing how irrational they are lessens the emotional response to these thoughts (and btw your emotions come from your thoughts).
I understood more of how the mind works by the time I sold my second house. This case was much worse because the local housing market had declined significantly. We ended up having to sell at a 30% loss vs what we paid for the house 8 years earlier! Despite the financial pain of this sale being significant, I wasn’t that emotionally upset. I was moving for a new job opportunity which came with a nice increase in income. Plus we always knew the local housing market was never going to be a great investment (the population was stable to declining and there was plenty of space to build). Knowing this, we treated the house as an expense for the lifestyle we wanted, not as an investment and it was a relatively small portion of our income. I know the price we sold at was the market price at the time. There wasn’t anything I could do so I simply had to accept the fact. I try very hard to not get upset about things that are out of my control since it’s a complete waste of time and energy. Easier said than done! But worth the effort.
A short while later, we were getting established in the new location, and moving forward again. I quickly forgot about our previous house. On the rare times I did think about it, I was glad it was off my mind, not upset about the financial loss. I was glad I didn’t have to arrange for mowing and other maintenance and all the hassle of trying to sell the house while living far away, while waiting for the local market to improve so I could get a higher sale price.
By now, astute readers that you are, maybe you can predict where I’m going with the home price analogy and the prices of other investments like stocks. The same anchoring effect plays a key role in stock market investing. There are a few differences. You are less emotionally attached to your stocks vs your home so that is a positive. In investing, it’s helps to be less emotional about your decisions. But it’s still money, which is a proxy for many things that are important so there is still clear emotional attachment to the value associated with your investments. On the downside, stocks decline in value much more often, and to a larger extent, than housing prices do (they also go up in value much more too). They are simply much more volatile. This causes a lot of the emotional swings in investing.
Anchoring is more problematic when it comes to losses. People hate losing things. In fact, as mentioned in Mind Against Money – Fear of Loss, people hate losing twice as much as they like gaining something of equivalent value.
So when the value of your stock investment declines and becomes a loss, it’s upsetting (when it goes up the same amount, it’s only half as emotionally effective on the upside…..unfair huh?). Different people react differently to these losses. Some change their investments with the hope of making the money back. Some hold on, unwilling to sell until the value has at least gone back up to what they paid. Others start to hate the investment that has “caused” them to lose money. Often then sell and then stay out of the stock market for a long time.
But the price of your investment is only a snapshot in time. It’s supposed to be a best-guess reflection of the future cash flow of that investment. The price history doesn’t matter. Maybe the price was higher in the past because investors had more optimistic expectations for the company. Maybe it was lower in the past. It doesn’t really matter. The current price is simply the best-guess current value of that investment based on expected future returns.
Investment gains are less problematic but are still an issue. Everyone loves to see their investments go up in value. But at some point, there is an urge to “lock in the gain” by selling. After selling, a new mental anchor point is set. Unfortunately (?), often the investment keeps going up, sometimes quite a bit (by the way, many great investors have a target holding period of forever……they buy for life since investment values, by definition, tend to go up over time forever). So if you sold, now that great investment return seems like a mistake because you left so much “money on the table”. Just think how much you would have had if you hadn’t sold so early? Or if the investment declines in value soon after you sold, you feel like a genius for “selling high”. This is very difficult to predict and is essentially out of our control so it’s a bit strange that our mind has such strong thoughts and associations with essentially random short-term fluctuations in price.
Market Timing is Nearly Impossible
As investors, we ideally forget about any past prices and try to look at the investments based on our current estimates of future value. Instead of buying or selling because an investment went up or down, we need to judge whether the current price is higher or lower than we think it should be based on our future earnings estimate. This is why there are so many analysts out there trying to estimate earnings and why adjustments to expected earnings moves stock prices. Remember that it’s a very difficult job though, which is why passive investing in the total market through low cost index funds is the best way to go.
We also need to remember that “the market” is often irrational. The market is just a collection of emotional human beings after all. So even if you have a better way to analyze the value of future earnings than anyone else (please let me know so I can become rich in the future too!) and you know the price is too low or too high, it may be a very long time before everyone else notices your brilliance and reprices the investment logically. A common saying in investing is that “the market can remain irrational for longer than you can remain solvent”.
When to Sell?
One of the biggest challenges is when to sell. Stock market prices typically go up (and a lot) beyond a rational price before any type of crash. It’s almost impossible to predict. So you may think the market is getting overpriced based on some metric like P/E ratio and feel like selling. But there are always a number of counterarguments as to why prices could keep climbing. And even if you’re right on a rational basis, it doesn’t mean prices won’t keep climbing.
What often happens is that investors sell, thinking they are being prudent because they can see a crash building (and they are usually right!). But then the market keeps climbing, often for years and with pretty large gains. This is why honest investors will say things like “I’ve predicted 11 of the last 4 recessions”. Often you miss out on really big gains if you sell in the later few years of a bull market when things seem a bit overpriced for a long time. That’s the situation the US stock market is in right now. Should you sell or hang on? I don’t know which will prove to be the right course of action when we look back in the future.
Let’s say when the crash comes, and it’s a 25% decline and you luckily sold before this crash. But it’s quite possible that you sold a bit too early, missing out on gains of more than this in your investment portfolio so you didn’t really come out ahead. Plus there is the added complication of buying back in at the “bottom” which is also impossible. Instead, you’ll buy back in too early or too late so you never get the full benefit of buying low after the crash.
These timing difficulties for both buying and selling are why many expert investors simply stay invested as buy-and-hold participants in the market and only change investments when something more fundamental changes in the long-term expected return of those investments.
If you think about it, the whole desire to try timing the market is because of anchoring, either based on a rational analysis or emotion. We get a number anchored in our head and then create an opinion (story) of whether current pricing is higher or lower than what it “should” be (i.e. our mental anchor number). But should we really get mentally anchored in designating “high” or “low” prices along the way? Again, it’s important to realize there aren’t truly “high” and “low” prices in the first place. These are the “market” prices at the time. We know prices of stocks are volatile so in hindsight we can look at past prices and show they were high or low. But doing so in real time is nearly impossible. And remember, you can generally be right by knowing whether prices or closer to “too high” or “too low” and still lose because they usually go even lower or higher than you thought.
What do I do?
I admit that I’m not immune to anchoring in investing. I often have an opinion of whether an investment is low or high relative to what it will be at some point in the future. However, I understand this is just an educated guess. What I’m trying to do is play probabilities based on the tendency for markets to go either too high or too low over cycles due to emotion. I also need to have a long time horizon. Short term timing is impossible but I believe longer cycle timing is possible to some extent. This is where I can have some advantage over the pros that need to show their “bets” paying off on a quarterly basis. I can’t imagine trying to be successful doing that. I also do this in a hedged way, using diversified index funds …. shifting allocations to over-weight or under-weight different asset classes. I also expect all this effort will at best gain me a percent or so in extra return over time and could easily end up costing me a percent instead. For me I like the challenge and it’s worth the financial risk since it won’t derail my financial future anyway.
What I’ve found over time is that the best way to do this is to rotate into investments that have declined sharply over a short period of time. You still have to be careful since these could be “value traps” meaning they become cheap for a very good reason and could continue declining or stay stagnant for a long period of time. So you need to do your research. But the steeper the decline, the more likely the investment was oversold. There are always real reasons for a sell off (earnings, a big change in industry or country dynamics, politics, etc) but it’s often overdone. If I see this, it captures my notice and I do some research. If I feel the investment is a good value, I’ll overweight some investment there with some “fun money” portion of my savings. I can’t predict any timing so I’m fully prepared to hold for many years but I’ve found the market usually corrects to a significant amount relatively quickly in the case of large and steep declines.
It’s much more challenging to predict a decline before it happens so if I feel something is getting very expensive, I either hold or steadily sell portions and invest them into areas that I think are better values. In other words I rebalance. Normally I’m in a regular range of allocations when reallocating but if valuations significantly diverge, I will consider extreme rebalancing where my allocations shift beyond my typical % values.
It’s also very difficult to recognize opportunities when price moves haven’t been as significant and quick. If it’s a slow upward progression, or slow decline, it’s much more difficult to predict future price movements.
Finally, since stock values will eventually go up over time, this “macro” rotation method is much more useful in looking for bargains. If something has declined a lot, the probability goes up that it will be a good long term investment (i.e. predicted future returns goes up). Even here, you have to be careful of value traps though. Consider Japan over the last several decades as an example.
Again, I only do this with extra “fun” money. For most of my personal savings (that I depend on), I am a buy-and-hold investor in low cost diversified index funds. This is the best way to go for your core portfolio.
Buy-and-Hold to Resist Anchoring
The most useful understanding of anchoring for investing is knowing with a high degree of certainty that future (long-term) prices will be higher than current prices. So don’t get anchored on the price you paid when you bought the investment. Don’t get anchored on the price you sold. Don’t get anchored on the current market price. Simply invest regularly in low cost market index funds while you are working and ignore the markets. You will do really well as long as you are saving aggressively and investing regularly.
Anyone have tips on how to avoid the emotional anchoring effect in investing? Since psychology is much more critical to being a successful investor than the math, please share any tips you have. I’d love to hear your thoughts.