Psychology and Investing: Anchoring

When estimating the unknown, we cleave to what we know.

Investors often fall prey to anchoring.

They get anchored on their own estimates of a company's earnings, or on last year's earnings.

For investors, anchoring behaviour manifests itself in placing undue emphasis on recent performance since this may be what instigated the investment decision in the first place.

When an investment is lagging, we may hold on to it because we cling to the price we paid for it, or its strong performance just before its decline, in an effort to "break even" or get back to what we paid for it.

We may cling to sub-par companies for years, rather than dumping them and getting on with our investment life.

It is costly to hold on to losers, though, and we may miss out on putting those invested funds to better use.



Overcoming Anchoring

It may be helpful to ask yourself the following questions about your stocks:

Would I buy this investment again?

And if not, why do I continue to own it?

Truthfully answering these questions can help you severe the anchors that may be a drag on your rational decision making.

Why You Shouldn't Invest in American Stocks

By Tim Hanson and Brian Richards
November 5, 2010

Before you get any ideas, let it be known that we love the NCAA tournament, Oreo cookies, and Saving Private Ryan. But when flipping through an issue of Fortune, an astoundingly hammy ad made me (Brian) stop cold.

In big, bold letters, it read: "When you invest in America, you're really just investing in yourself."

The ad is for the SPDR Dow Jones Industrial Average ETF (NYSE: DIA), and we have nothing against that exchange-traded fund per se -- it has low expenses and does what it says it will, tracking the 30 stocks in the Dow.

The ad, though, sells an investment in a way that undermines the investor -- by pandering to patriotic emotions. Here's more of the text:

There's an unspoken agreement in America that each generation should leave this country in better shape than they found it. Maybe that's why the U.S. economy has been growing since the Industrial Revolution. Everyone tries to do their part. If you believe this covenant still exists today, consider the SPDR Dow Jones Industrial Average ETF. [emphasis ours]
A touch melodramatic, eh?

We'll cut straight to why you shouldn't invest in American stocks: Because you are patriotic and sentimental about America. Kudos if you are those things -- just don't invest for those reasons.

Losing money is not patriotic
Consider, for example, Ford (NYSE: F) and Toyota (NYSE: TM). Are you more patriotic if you owned Ford over the past decade? No, you're just poorer (though both have lost money for investors, given how difficult it is to compete in the cyclical auto industry).

And while you might have thought it would help Ford out to purchase its stock when it was imploding in 2009, the fact is, when you buy a stock in the stock market, that money does not go to the company. Instead, it goes to a person who bought the stock from some other person.

So rather than bail out Ford, you were actually bailing out the person who bought Ford before you. That said, Ford has turned out to be a great investment since 2009, thanks to its return to profitability under Alan Mulally -- for reasons that have nothing to with patriotism.

The point is, companies only raise money during offerings. If you're buying or selling stock on the open market during a regular trading day, it generally will have no effect on the operations of the underlying company.

And even when it comes to offerings, you shouldn't buy shares of a company because you think it needs help, or because it might be patriotic to do so -- as the marketing surrounding the inevitable GM IPO will almost certainly imply. Most companies, when push comes to shove, won't return that thoughtfulness to their shareholders.

There's a larger lesson here
Patriotism, however, is only one of the ways that you might get suckered into making a poor investment decision. Others include buying into a rising stock for fear of missing out on gains (as so many did during the tech bubble), or selling a stock that's dropping solely because you're afraid it might go lower. Or as The Wall Street Journal explained recently:

Everyone develops attachments that can be irrational sometimes, whether to a house, a car, even a person. People can also get overly attached to a particular investment, believing it will reach -- or return to -- a certain price. Or they may place too much importance on one piece of information when making an investment decision. These are examples of anchoring bias, which causes the investor to hold on to the asset for longer than they should.

So there's a large lesson here, and it's this: An emotional investment is bad investment.

Don't believe us? Thankfully, there's now an entire field -- behavioral finance -- devoted to studying the ways in which our investing hearts get the best of our investing minds (actually most emotion happens in the brain as well, but stay with us).

Rather than rehash it all, we'll quote a Stanford study sums it up unequivocally: "Emotions can get in the way of making prudent financial decisions." We also recommend you read the fabulous Jason Zweig book, Your Money & Your Brain.

But back to America
Frankly, we think it's irresponsible for an ad agency to pull your patriotic heartstrings to make you want to buy an investment product that tracks the Dow 30. Not only is it intellectually strange -- assuming your dollars do go to support the business you buy, wouldn't it be more patriotic to buy shares of a collection of American small business, rather than 30 massive multinationals? -- it's just flat-out inane. A sense of civic duty is no reason to buy a stock or ETF, period.

Yet none other than investing icon Warren Buffett went to the exact same well when, during the peak of the financial crisis, he published his now-famous New York Times op/ed titled "Buy American. I Am."

To be fair, editorial page editors often pick the titles of editorial page editorials, so Buffett may not have been responsible for that slightly over-the-top headline (though who are we to criticize for an over-the-top headline?). Furthermore, the headline isn't even consistent with what Buffett's actually been buying at his investment vehicle, Berkshire Hathaway.

The holding company now owns stakes in China's BYD, the U.K.'s GlaxoSmithKline (NYSE: GSK), Switzerland's Nestle, and France's -- yes, France's -- Sanofi-Aventis (NYSE: SNY). What's more, Berkshire owns sizable stakes in ostensibly American companies such as Coca-Cola (NYSE: KO) and Wal-Mart (NYSE: WMT) that have investment and growth abroad -- key parts of their business strategies going forward.

No, Buffett is not a hypocrite
This is all very smart -- both for the companies and for Buffett. Emerging markets are growing faster than the U.S. and have less ominous debt profiles. The dollar is weakening relative to those currencies. It makes sense to have a healthy dose of foreign exposure today! In fact, we'll go so far as to predict that if you buy foreign stocks, you'll earn better investment returns and end up paying more in capital gains taxes -- money that will actually go to prop up America (if that's the sort of thing you're looking to do).

All told, the takeaway from Buffett's editorial was not "Buy American," but rather found farther down in the copy: "A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors." Sometimes, that means Buy American, and other times it means Buy Abroad. But all the time, it means that you should make smart, unemotional decisions with your investment capital.



http://www.fool.com/investing/general/2010/11/05/why-you-shouldnt-invest-in-american-stocks.aspx

Curb irrational behaviour: Be aware of ANCHORING, a common mind trap when investing.

Curb irrational behaviour

Annette Sampson
April 7, 2010

The strategy To avoid common mind traps when investing.

You're talking about fear and greed, right? There's no doubt fear and greed are behind a lot of investor behaviour - much of it is irrational. But a school of study, known as "behavioural finance", has demonstrated our minds are hard-wired to react in certain ways. Even if we make concerted efforts to avoid fear and greed, our thought patterns may lead us to make investment decisions that could prove costly.


Such as? There are many aspects to behavioural finance but one area Tyndall Investment Management's Australian equities team believes may be influencing investor behaviour at the moment is "anchoring".  In simple terms, this is the tendency we have to base our judgment on a piece of initial information then stick with it even if other information becomes available.

To show how it works, Tyndall looked at research by two behavioural finance experts, Amos Tversky and Daniel Kahneman. They asked two groups of people what percentage of the United Nations comprised African countries. 

• The first group was asked whether it was above or below 10 per cent; 
• the second whether it was above or below 65 per cent. 

The numbers were supposedly chosen randomly (the groups didn't know the "random" spin of the wheel was rigged) but it still influenced their estimates.

• The first group, having a lower "random" figure estimated an average 25 per cent of African countries; 
• the second 45 per cent.

In the absence of real information, the test groups tended to "anchor" their estimates on any information available rather than thinking independently.

In another study, psychologist Ward Edwards asked people to imagine 100 bags of poker chips. Each bag contained 1000 chips but 45 contained 700 black chips and 300 red while 55 contained 300 black and 700 red.

• When asked what the probability was of selecting a bag with mostly black chips, most of the test subjects got it right. 
• The answer was 45 per cent.

But he then asked them to imagine 12 chips were randomly selected from the bag - eight black and four red. The chips were put back and the respondents were asked whether they would change their first answer in response to the new information.

• Many said the probability of the bag containing mostly black chips was unchanged at 45 per cent. 
• Most said the likelihood was less than 75 per cent. 
• But calculated mathematically, the bag was 96.04 per cent likely to contain mostly black chips. 
• The respondents didn't take account of the new information.

But how does that relate to my reactions to investment markets? Tyndall says the same research has been conducted on analysts' reactions to company earnings announcements.

• They often don't revise their estimates enough when they receive new information, resulting in a string of earnings "surprises". 
• It says the recent rally has resulted in largely favourable earnings forecasts but if the numbers don't live up to expectations and investors haven't factored in changing circumstances to their thinking, the market could fall sharply.

It says basing future investment performance on past returns is another common example of anchoring.

• After shares fell more than 38 per cent in 2008, most investors expected a dud 2009. 
• Certainly no one was predicting a rise of 37 per cent. Investors who switched money out of shares paid dearly.

So how do I avoid this trap?

• Understanding these behaviours and being aware of them can help you make more informed and rational decisions. 
• Even better, Tyndall says, it can give you an edge, allowing you to identify, and make money from, mispricing opportunities that come about because of other people's irrational behaviour.

Old favourites, such as having a diversified portfolio, getting good professional help and looking to the long term can help.

http://www.smh.com.au/news/business/money/investment/curb-irrational-behaviour/2010/04/06/1270374188426.html?page=fullpage#contentSwap1

Why investors behave the way they do

Why investors behave the way they do
Published: 2009/04/01

Learning from other market players’ mistakes; analysing how and what they think, can help an investor emerge as a winner in the market

In recent years, behavioural finance has been gaining grounds in trying to explain the financial anomalies in the stock market. These anomalies, which cannot be addressed by traditional financial theory such as the market efficiency theory may sound purely theoretical, but you cannot brush aside the need to understand the psychology of investors as it plays a big part in driving the stock market.

What is Behavioural Finance?


Behavioural finance is the study to explain the financial behaviour from the psychological aspect. Over the years, market psychologists have discovered that the two primary emotions that drive investors' risk-taking behaviour are hope and fear. There are a few key behavioural concepts that will help us to understand why some of us behave in certain ways when it comes to making investment decisions. In this article, we talk about four of such concepts:

* Regret theory


Regret, a simple enough concept to understand by any layman, refers to the emotional experience that one goes through when confronted with the wrong decision that he or she has made. It manifests itself in the form of pain when one feels responsible for not doing the right thing. When you look back at your investment history, try to recall the state you were in when you missed the chance to cut losses or missed the opportunity to buy a stock that you knew you should have bought because it was considered a good buy. Try and remember how you felt when the price of that particular stock that you did not buy increased subsequently. This emotion often becomes embedded in someone's mind in such a way that it regulates his or her future actions and decisions.

As a result, most investors make it a habit to avoid selling a loss-making stock and instead hope that the price will rebound eventually - all this, to avoid the feeling of regret. They would much rather make a paper loss than admit that they have made a mistake. In some cases, where the bad decisions happen to be recommended by their financial advisers, investors will put the blame on the advisers to avoid regret.

* Prospect theory

Prospect theory developed by Daniel Kahneman and Amos Tversky (1979), states that "we have an irrational tendency to be less willing to gamble with profits than with losses". Kahneman and Tversky found that when confronted with the choice between accepting a sure loss and taking a chance, most people will choose the latter. This phenomenon is called "loss aversion", which basically means that in general, people hate to lose. So, when faced with a situation involving loss, they become risk takers; they take the chance even if there is only the slightest hope of not having to lose.

On the other hand, when presented with a sure gain, they usually become risk-averse. Investors who behave this way tend to mark their stocks to the price that they originally paid to secure them and not to market. As such, they aim to get even before closing out a position. This type of investors usually ends up holding on to their loss-making stocks for far too long, which may very well prove detrimental to them in the end.


* Overconfidence

It is human nature for us to over-estimate our abilities and shower ourselves with a little too much confidence, i.e, overconfidence. Studies show that investors are often overconfident when it comes to their ability to predict the market's direction. Oddly enough, this is something that is more prominent among novice investors. Compared to experienced investors, those who are new to the market tend to set higher return expectations and end up being overwhelmed by the unfavourable outcome. As a result of overconfidence, some investors tend to trade too frequently only to get unsatisfactory returns or worse yet, losses. With the convenience of online trading, some even quit their full-time jobs to do day trading, thinking that they have the ability to predict the market and earn fast money. These are the people that usually end up getting burned if they do so without proper understanding of what they have been buying and selling, especially when the market is highly volatile.


* Anchoring


This is a behavioural phenomenon in which people tend to extrapolate the past into the future, putting heavier weight on the recent past. At times, when there are new announcements from companies, analysts fail to adjust their earnings forecast for the companies to reflect the latest information due to the anchoring effect. As a result, they land themselves with a few surprises when positive news become more positive and vice versa.

What has been discussed above are a few common behavioural phenomena experienced by investors that are useful to know. By understanding the psychology behind investors' behaviours, you can learn to recognise mistakes and avoid making such mistakes yourself. Learning from other market players' mistakes; analysing how and what they think, can help you emerge as a winner in the market.

Securities Industry Development Corp, the leading capital markets education, training and information resource provider in Asean, is the training and development arm of the Securities Commission, Malaysia. It was established in 1994 and incorporated in 2007.

http://www.btimes.com.my/Current_News/BTIMES/articles/SIDC9/Article/


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Behavioural Finance

Behavioral Finance

By Albert Phung

Whether it's mental accounting, irrelevant anchoring or just following the herd, chances are we've all been guilty of at least some of the biases and irrational behavior highlighted in this tutorial. Now that you can identify some of the biases, it's time to apply that knowledge to your own investing and if need be take corrective action. Hopefully, your future financial decisions will be a bit more rational and lot more lucrative as well.

Here is a summary:

• Conventional finance is based on the theories which describe people for the most part behave logically and rationally. People started to question this point of view as there have been anomalies, which are events that conventional finance has a difficult time in explaining.
  
• Three of the biggest contributors to the field are psychologists, Drs. Daniel Kahneman and Amos Tversky, and economist, Richard Thaler.
  
• The concept of anchoring draws upon the tendency for us to attach or "anchor" our thoughts around a reference point despite the fact that it may not have any logical relevance to the decision at hand.
  
• Mental accounting refers to the tendency for people to divide their money into separate accounts based on criteria like the source and intent for the money. Furthermore, the importance of the funds in each account also varies depending upon the money's source and intent.
  
• Seeing is not necessarily believing as we also have confirmation and hindsight biases. Confirmation bias refers to how people tend to more attentive towards new information that confirms their own preconceived options about a subject. The hindsight bias represents how people believe that after the fact, the occurrence of an event was completely obvious.
  
• The gambler's fallacy refers to an incorrect interpretation of statistics where someone believes that the occurrence of a random independent event would somehow cause another random independent event less likely to happen.
  
• Herd behavior represents the preference for individuals to mimic the behaviors or actions of a larger sized group.
  
• Overconfidence represents the tendency for an investor to overestimate his or her ability in performing some action/task.
  
• Overreaction occurs when one reacts to a piece of news in a way that is greater than actual impact of the news.
  
• Prospect theory refers to an idea created by Drs. Kahneman and Tversky that essentially determined that people do not encode equal levels of joy and pain to the same effect. The average individuals tend to be more loss sensitive (in the sense that a he/she will feel more pain in receiving a loss compared to the amount of joy felt from receiving an equal amount of gain).
  

Table of Contents
1) Behavioral Finance: Introduction
2) Behavioral Finance: Background
3) Behavioral Finance: Anomalies
4) Behavioral Finance: Key Concepts - Anchoring
5) Behavioral Finance: Key Concepts - Mental Accounting
6) Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
7) Behavioral Finance: Key Concepts - Gambler's Fallacy
8) Behavioral Finance: Key Concepts - Herd Behavior
9) Behavioral Finance: Key Concepts - Overconfidence
10) Behavioral Finance: Key Concepts - Overreaction and Availability Bias
11) Behavioral Finance: Key Concepts - Prospect Theory
12) Behavioral Finance: Conclusion

Heuristic-driven biases: 3. Anchoring

3. Anchoring

After forming an opinon, people are often unwilling to change it, even though they receive new information that is relevant.

Suppose that investors have formed an opinion that company A has above-average long-term earnings prospect. Suddenly, A reports much lower earnings than expected. Thanks to anchoring (also referred to as conservatism), investors will persist in the belief that the compny is above-average and will not react sufficiently to the bad news. So, on the day of earnings announcement the stock price would move very little. Gradually, however, the stock price would drift downwards over a period of time as investors shed their initial conservatism.

Anchoring manifests itself in a phenomenon called the "post-earnings announcement drift," which is well-documented empirically.

Companies that report unexpectedly bad (good) earnings news generally produce unusually low (high) returns after the announcement.