It’s Time to Weigh Anchor

‘Anchoring’ is the term used by behavioral psychologists to describe the tendency of people to hold a fixed point of reference based upon their experiences, values or beliefs. This becomes the familiar position in relation to which all future decisions are made, unless and until a new anchor point is chosen.

In 2002, Professor Daniel Kahneman shared the Nobel Prize in economics ‘for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty’.

As investors, our natural instinct is to seek shelter from the storms of financial market uncertainty by dropping anchor in the safe harbours where we are familiar with our surroundings. We feel safe and secure in our comfort zones and protected from external threats.

Through a series of research studies, Kahneman, (along with Amos Tversky) demonstrated that people struggle to properly analyze complex questions when the outcomes are uncertain and prefer to rely on shortcuts or rules of thumb to make decisions. These mental shortcuts based on intuition are often inconsistent with logically sound decisions that are based on the principles of mathematical probability.

In a classic experiment, two groups were asked to guess the proportion of African countries in the United Nations. The first group was asked whether the answer was more or less than 10 per cent and the median response was 25 per cent. The second group was asked whether the answer was higher or lower than 65 per cent and this produced a median response of 45 per cent. The way in which the questions had been framed had effectively served as an anchor for the respondents even though it should have been completely irrelevant to the answers given.

Much of human behavior is intuitive and this generally produces successful outcomes. In some cases there is a need to correct the intuitive judgment, but there is a strong bias for this to remain as the anchor point until proven wrong.

For example, an investor might prefer to invest with a fund manager that has beaten the market three years in a row believing that this demonstrates the skill of the manager when in fact such a track record would be statistically insignificant. Luck could have played just as much a part in the success enjoyed by the fund manager when measured over such a short time period.

The research shows that people are highly sensitive to deviations away from a familiar reference point. Most individuals are more averse to losses than they are attracted to gains of the same magnitude. In fact Kahneman and Tversky estimate that the value attached to a moderate loss is about twice the value placed on an equally large gain.

This helps to explain why a person who invests in a company at $10 a share will often insist on holding the shares for years afterwards, even after the price has collapsed to $4 a share. By anchoring to the memory of past glories the investor doggedly clings to the belief that since the company was once worth $10 it must rise to that level at a future date. In holding this belief the investor avoids having to confront the prospect of a substantial capital loss even when there is no good reason to expect that the share price will recover.

Anchoring also clarifies why people who inherit shares from a deceased estate will sometimes exhibit a strong resolve not to sell those shares regardless of the market price or the prospects for the company. This is because the shares have a personal and symbolic value that is unrelated to their commercial value.

Investors would be wise to weigh anchor and chart a course for their portfolio based on a disciplined and rational framework.