Biases in your thinking could be costing you when it comes to your investments, says Hannes Viljoen. In this seven-part series, he explains how to overcome this problem.
This is part 5: Anchoring.
Imagine you walk into a store to buy a pair of shoes. You spot a pair you like and the tag reads R3 000. You turn over the tag and to your surprise, you see the item is marked down 40% to R1 800. Bargain. You are offered the opportunity to purchase an item with a value of R3 000 for only R1 800.
Except, the store worked the other way around, they first determined what price they would like to sell the item at, inflated the price to the number you first saw, and then offered you a discount of 40% out of the goodness of their hearts. Bless them.
If someone asks you what the Rand/USD exchange rate will be within a year, how would you respond? Would you ask yourself where the Rand is currently trading? What was the Rand performance over the past year? Also, do not forget that the currency traded at R19/$ not that long ago.
On the other hand, would your response be that you first want to determine what you believe a fair value is, based on fundamentals, and make your expectations from there?
Envisage that you bought your first home four years ago for R2.6 million. The family has grown and you are looking to acquire something more spacious. The first offer you receive is cheeky R2.7 million. Is your reaction, "That is ridiculous, we bought the house for a mere R100k less four years ago" or "Given the current state of the market, sentiment and fundamentals, that is a fair price".
The R1 800 shoe price, R19/$ exchange rate and R2.6 million you paid for your first house are all anchors that influence our decisions.
On the sell side, your original purchase price is usually the anchor. If the stock is below the original purchase price, and you are not convinced about the fundamentals of the company any more, you just want to break even before you sell, so that you do not make a loss (remember loss aversion).
Alternatively, if the price is increased, are you happy with a 10%, 20% or 30% return?
On the buy side, if the stock you want to buy recently reached an all-time high, do you wait until it has pulled back a little bit before you make the buy decision? Even though you believe the upside potential is much more than what the security is currently trading at?
This is not only relevant to single stocks, a five-year compounded return from a manager can act as an anchor of expected future returns. On the other hand, the 10-year return of an asset class, which might not be a bad thing if base rates and reversion to the mean are aspects you take into account during your investment decision-making process.
To completely avoid anchoring in the investment or any other decision-making situation is tough. Think about a time you heard what the salary of a colleague was compared to yours. Did you ask yourself what a market related salary was, what value the colleague added or compared it to yours and thought it was utterly ridiculous, and thought by yourself that you are going to look for another job? Maybe a lower salary is justified given the value that you add and what you bring to the firm.
If you want to reduce the influence of anchoring on your decision, ask yourself what the value of an item is, to you, before looking at the actual price.
If you already have a stock in your portfolio you are reviewing, determine with a clean slate what you believe an accurate value is, then look at the price and make a decision.
If you are attempting the impossible task of determining a fair value of the Rand, do it on a clean slate and then imply if it is over or under valued.
If you want to sell your house, do some homework on the average selling price per square meter in your area over the past couple of years and then infer a reasonable price.
I understand there were some unforgettable memories made in the house and that the finishes are much nicer than the neighbors, but aim to be reasonable.
And sometimes, just sometimes, if you really want that pair of shoes, just go ahead and buy it!
Hannes Viljoen is a chartered financial analyst. Views expressed are his own.