How to recognize anchoring
What would be the reason for someone to think that a Valeant Pharmaceuticals share is still worth US$200? There may be many reasons for sure, but one of them is bound to be that the investor first bought the share at US$200 and, therefore, has anchored themselves to that price as the share’s value.
What is anchoring?
Anchoring is when we fixate on past information and then base our future investment decisions on this. One way is to anchor to the price you originally bought a stock for, but another is to anchor to the price target you expect it to achieve and then stick to your anchor even when new information suggests you should do otherwise.
Why is anchoring a problem?
Let’s say you bought Valeant Pharmaceuticals share at US$200 in April 2015, but then the price-hike scandal hit. Despite this turn of events, you bought it at $200 so your anchor remained that the stock cannot be worth less than this. But by the end of 2015, the share price was about half your buying price, and you would have lost 50% on your investment (plus even more if you had still kept it till today).
You say Valeant Pharmaceuticals share is still worth US$200? $VRX - Tweet This
The world around us changes, and so do the fundamentals of the companies you invest in; as there are a variety of influences that can affect share price. Sticking to your anchor doesn’t make rational sense, as most of the time your anchor might not even have been set by rational principles. Yet, even if it was rationally set, as things change so should your estimated value.
How to deal with anchoring
Research has not really reached a consensus about who is more or less prone to be affected by anchoring. Some studies have found that experts or people with better cognitive abilities are less affected by anchoring. Others have shown that even court judges are affected by anchoring when they sentence people. One thing most studies have in common though, is that everyone seems to be affected by anchoring at least to some extent.
As with many of our cognitive flaws, awareness is the best medicine. Just by being aware of your anchor and acknowledging that it can become irrelevant due to new information, should you be able to deal with this bias. And when it comes to stocks, if you should anchor to something, anchor to value, not price.
Article by Alexander Wetterling, Become a Better Investor