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When required to estimate a value with unknown magnitude, investors generally
begin by envisioning some initial default number, an anchor.
Which they then adjust up or down, due to subsequent information, and
analysis about a particular stock, or index.
The anchor, once fine tuned and
reassessed, then matures into a final estimate.
Research has demonstrated that regardless of how the initial anchors are chosen,
investors tend to adjust their anchors insufficiently, and
produce approximations that are consequently biased.
Investors are generally better at estimating directive comparisons
rather than absolute figures.
Just to give an example, suppose I asked you whether the valuation of Uber,
which is basically a cab service provider,
is greater than $8 billion or less than $8 billion.
Obviously, you will answer that it is either about 8 or less than 8.
And if I were to then ask you to guess an absolute valuation for Uber,
your estimate would probably fall somewhere near $8 billion.
And not anywhere close to $50 billion or $1 billion,
because you are likely to subject to anchoring by your previous response,
and you're likely to anchor your number to the $8 billion mark.
So anchoring and adjustment is essentially a psychological heuristic
that influences the way investors intuit about probabilities.
Investors exhibiting this kind of a bias are often influenced by
arbitrary levels of price indices, and then cling onto these
numbers when they face questions like, should I buy or sell the security?
Or, is the market overvalued or undervalued, and so on.
This is especially true when introduction of information regarding the security or
the index further complicates the assessment situation.
Rational investors,
on the other hand, treat these new pieces of information objectively, and
do not reflect on purchase prices or target prices in deciding how to act.
Anchoring and adjustment bias, however, implies that investors
perceive new information through essentially a warped lens.
So they place undue emphasis on statistically
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arbitrary and psychologically bit of mind anchor points.
Such investor decision making therefore
tends to deviate from the neoclassical proscribed rational norms.
Let me give you an example for anchoring and adjustment bias.
Suppose I owned a stock in Apple, and
let's say that I am a fairly astute investor.
And I have recently discovered some good information about Apple.
So my task is, so what I'm trying to do is essentially to evaluate this information
for the purpose of deciding whether I should be increasing my stock holding, or
decreasing my stock holding, or simply maintaining my holdings in Apple stock.
So let's say that I bought Apple stock way back in August 2015 when
the price was $103.
And the Apple stock price of course reached a level of $122 in November 2015,
and the stock price since then has come down, and it's about $100 in March, 2016.
So essentially what I've done is I bought stock at $103,
it went up to $122 in November, and it's come down to $100 in March, 2016.
So I may have contemplated selling the stock in November, but
I did not sell it, and unfortunately Apple stock has dropped by $22.
And if I rationally feel that I've lost close to 20%,
I've lost $22 on an investment of $100 over these
five months then, and I prefer to sell my shares in Apple
only after they return to the recent highs of $122.
Then I maybe suffering from anchoring and adjustment bias.
So now let's basically analyze this case.
Most investors are confronted with situations similar to this one.
They decide to invest in a stock.
The stock price goes up, and then declines, and
then investors become conflicted.
And therefore, most evaluate the situation to determine
whether to hold on to the stock or to sell it off.
A rational investor would examine the firm's performance,
the company's performance, and make an objective assessment
of its business fundamentals and then decide to buy, hold or sell the stock.
However, an irrational investor, like me, say, even after going through the process,
and the trouble of performing the analysis that a rational investor will do, and
perform all the rational analysus that I may perform.
I may still permit cognitive errors to cloud my decision.
So I may irrationally disregard the results of my research and
anchor myself to the $122 figure, refusing to sell Apple
stocks unless Apple share price, once again, achieves that price.
This type of response results in an irrational behavior and should be avoided.
And how to basically ameliorate this kind of a bias, anchoring and adjustment bias.
So, from an investment perspective, awareness is the best counter-measure for
anchoring and adjustment bias.
I should be asking myself the question, am I analyzing the investment
situation rationally, or am I holding out to attain an anchor price?
So when making forecasts about the magnitude or direction of markets or
securities, I should ask myself, is my estimate rational or
am I anchoring to some past performance figures?
Taking these sorts of actions is very likely to root out any anchoring and
adjustment bias that may have taken hold in my investment decisions.
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Vaidya NathanLecturer
