Over my fifteen year investing career, I have made so many mistakes that I have lost count. Some of these were made due to poor analysis of the business, some were made due to inadequate research, and countless more blunders were made treading outside of my areas of expertise. However, many times, the mistakes were a result of mental errors, better known as cognitive biases. These biases occur when an investor takes mental shortcuts which can often lead to errors in decision making.
In this article I’d like to focus on the anchoring bias, which, for me personally, has been the most costly cognitive bias that has resulted in countless trading losses, as well as multiple missed opportunities.
Anchoring involves basing a decision on a recent reference point even though the reference point has no relevance to the current decision. This often happens during price negotiations. When my wife and I were looking to buy a house that was listed for sale, during the price negotiation process, the reference point was the asking price. Our realtor, representing both sides of the sale used the anchoring effect to her advantage when she suggested making an offer three to five percent below the list price. She told us the only consideration was to not make an offer so far below the asking price that it would be insulting to the seller. Looking back, the fact that she set the anchor on the list price most likely influenced the price we eventually paid for the house, and improved the realtor’s odds of negotiating a price that was acceptable to the buyer (us) and the seller, thus locking in a sizeable commission for her effort.
At it’s essence, buying and selling stock in the public markets is a price negotiation similar to buying a house. The anchoring bias often comes into play when an investor is considering buying or selling a stock and the investor mistakenly uses a recent stock price as a reference point to make their buy or sell decision, and from there they insufficiently adjust the price up or down to arrive at a fair value estimate.
When investors are looking at recent stock prices, whether the prices are above or below the current price, they should be asking the question to themselves “is the current price an attractive stock price in relation to the company’s future prospects, ignoring what the stock has traded at recently?” This is a difficult question that takes a lot of mental effort and work to get to an answer. So instead, what the mind often unconsciously does in this case is it substitutes a question that is much easier to answer, but not nearly as relevant, such as “is this a reasonable price to pay for this stock in relation to recent reference prices?” The resulting answer is often wildly misleading, and can often result in investors paying a price for a stock that is much too high or in the case of selling, a price that is much too low. It can also lead to missed opportunities in cases where a stock looks expensive in relation to recent reference prices, but is actually still quite cheap on a fundamental basis.
My most glaring instance of anchoring happened in 2003 when I came across a company called MTY Food Group (MTY.T). In the course of my research, I had noticed that the CEO had recently purchased 20% of the total shares outstanding from two other significant shareholders at 25 cents per share. At the time, the shares were trading at 30 cents, which resulted in a price to earnings ratio of about 3X, which was an absurdly cheap valuation for such a high quality business. However, I anchored onto that 25 cent reference point, and wouldn’t budge on my bid of 30 cents, and shortly after, the stock took off on it’s way to a 10,000% gain over 10 years.
In my experience, the most costly anchoring errors have usually happened when I have missed buying a growth stock like MTY Food Group at lower prices. Because I refused to pay up from the recent stock price that was much lower, these stocks have often gone on to appreciate in price hundreds of percent without having me as a shareholder.
Along similar lines, another group of costly anchoring errors has occurred when I have owned a growth stock bought at lower levels. As the value of the stock increased, I had a really hard time averaging up because it just didn’t come naturally to me to pay double what I had previously paid, even though the stock may have been relatively cheaper because the company’s value may have tripled due to improving fundamentals.
Another situation where anchoring has wreaked havoc on my portfolio returns is after I have sold a stock that has continued to appreciate much higher than where I sold. The price where I sold often becomes the anchor price, and there is often post-sale remorse as it continues to go up after I’ve sold. In the past, even though these stocks were still on my watchlist, I would often stop tracking them closely, because it was so painful to continue to follow a company that was up 100% or 200% from where I sold.
The same anchoring error can also happen when a stock price falls from a recent higher price. This often happens in the case of a stock with deteriorating fundamentals. For example, if bad news is released from a company and you determine it has dropped the value of the company by about 40%. But let’s say the stock is down only 20%, many investors will make the mistake of buying the stock in this scenario, because they determine the stock to be a bargain in relation to the higher anchor price where it traded at the day before. This is despite the fact that the value of the company has dropped much more than the stock price has. I have made this mistake a handful of times in the past, and it is usually in stocks with deteriorating business fundamentals.
Solutions to combat the anchoring bias
Although the anchoring bias can be very difficult to overcome, the following strategies may help dull the effects of anchoring when you think it may be wreaking havoc on your investment decisions:
1) First, I think it is important to be acutely aware of the anchoring bias and realize that it comes into play to a certain extent with almost every buy or sell decision. Whether it is the 52 week high, 52 week low, the price you initially looked at the stock price, or the price at which it traded at 2 years ago when it was a fraction of today’s price, I think it’s helpful to identify what the anchor price may be in each situation. I think you do need to be careful, because focusing on the anchor price could intensify it’s effect. However, if you can recognize that there is an anchor at play, you can devise a strategy to help minimize it.
2) In 2001 Galinsky and Mussweiler proposed a strategy to resist the anchoring effect. They suggested that negotiators (investors) focus their attention and search their memory for arguments against the anchor. For example, in the case where a stock has moved sharply off it’s 52 week low, where anchoring to the 52 week low may come into play, one could search their memory for previous instances of missed opportunities in similar situations where multi-bagger stocks were missed due to anchoring. This year, I started to keep an investment decision journal so that I can go back and analyze these missed opportunities and faulty decisions with less hindsight bias.
3) A very smart investor has suggested having a “wall of shame” with long term price charts of multi-bagger stocks and circling the price at the lower left corner of the chart where you had anchored and missed the opportunity. When you feel you might be subject to the anchoring effect, you could look at your “wall of shame” which might lessen the weight of the anchor.
4) In Thinking Fast and Slow, Daniel Kahneman suggests deliberately “thinking the opposite” to help deal with the anchoring bias in price negotiations. In a situation where there is likely a strong anchor, one could ask the question “despite my being influenced by price anchoring, is this stock attractively priced in relation to it’s future business prospects at today’s price, ignoring what price it traded at recently?” Instead of focusing on the price that it recently traded at, focusing on the expected value of the stock two or three years into the future, one may be able to reduce the weight of the anchor. In 2003, had I focused on the future business prospects and expected value of MTY Food Group a few years out, which could have been estimated above $2 per share, it may have yielded a much different reference point than the $0.25 anchor, and I may have been willing to pay up instead of sucking my thumb and holding out for a cheaper price.
One of the first times I recall starting to have some success reducing this anchoring bias was with a company called Paladin Labs. Paladin was a specialty pharmaceutical company that had a long history of profitable growth and was run by a superb management team. I first looked at Paladin in 2002 when it was trading at $4 per share. At the time, their profitability was erratic, but they had $3.75 per share in cash. I was waiting for it to fall below net cash, and it never got there, and soon after that, the stock began a long ascent upwards as the company started to show consistently profitable growth. I continued following Paladin, but I just couldn’t bring myself to pay multiples of that $4 stock price where I originally missed it. At the periodic mention by a friend (who smartly bought and held a large position at a much lower price), I started looking at Paladin again after the CEO, Jonathan Goodman, was seriously injured in 2011 and the stock took a nosedive. I figured they had a strong management team in place that could provide a seamless transition in leadership, and the business fundamentals were still intact. I was still anchored on the $4 price I initially looked at Paladin, but by focusing on the reasonable valuation in relation to current and future business prospects, I was able to get over the $4 anchor and take a position in Paladin at $35, which went on to be acquired two and a half years later at a price 300% higher than the 2011 price.
You have to be willing to change your mind as new facts come into the story of a stock. For example, there is a little microcap company called CRH Medical (CRH.T) that I looked at in late 2012. At the time, CRH distributed a medical product that was used to treat hemorrhoids. Spending a whole weekend researching hemorrhoid treatments was probably the low point in my life, but around this time, the stock was trading at $0.30, and it was trading at a little over 1X revenues, and about 5X free cash flow, which is very cheap for a medical products company. There was a challenge ahead, as they were rolling out a direct sales and marketing team that would probably temporarily depress earnings. So I decided to pass on the stock. Fast forward two and a half years to today. The company had fallen off my radar, but a friend who is a sharp investor (and much less susceptible to the anchoring bias than I am) mentioned the company to me recently and suggested I take a fresh look. Here the company is 1200% higher than where I initially looked at it, but they have recently done a transformational acquisition and have grown their product sales in the meantime. In the past, I would have had trouble even revisiting an idea like this due to the emotional torture of passing when it was trading at a fraction of where it is today. But it’s a stock idea I plan to spend some time on in the near future, and will do my best to focus on the expected value of the company a few years out, trying my best to ignore the $0.30 CRH traded at a few years ago.
5) Some investors try to combat this bias by initially buying (or selling) in a few small initial chunks at the current price. This may help to reset the anchor to a price closer to the current price. Two of my largest portfolio positions were each up 200% in the year before I bought them last year. I didn’t realize this at the time until a friend recently pointed out this strategy, but when I went back to analyze my trading in these positions, I initially bought a small chunk of each stock, and then about one month later, I started buying more aggressively as the price stayed in the trading range. I have also noticed I have used this strategy with averaging up on currently held positions, where I add in small chunks. By using this strategy, maybe my investment mind is subconsciously waiting for direction from the market for what to do next, but I think buying the initial small chunk or adding to existing positions in small chunks helps to reset the anchor closer to the current price. So in the MTY Food Group example, I could have bought a small amount at the $.30 ask price to reset the anchor, waited a few weeks, and then started to aggressively buy around that price, as it traded in that range for a number of months.
6) In the case of anchoring in relation to where you sold a stock at recently, one mental trick I have used recently to combat the anchoring effect is to think about the sale proceeds in that position being reinvested into a new position that was up as much or more than the stock you sold. It is painful to think of the gains left on the table after I have sold a stock that has gone up, however, if I think of a different stock that was purchased around the same time that is up as much or more, it makes it easier to repurchase the shares in the future at a higher price. For example, in 2014, I sold part of my position in Biosyent (RX.V) at $6.50 for a few reasons, mostly related to valuation. The shares continued to appreciate and hit $12 earlier this year. However, recently I re-acquired shares in Biosyent (RX.V) after they fell back to $8. I used the strategy of thinking about expected value a few years out to get over the $6.50 anchor, but I also thought about the gain I had in shares in another stock that I acquired around the same time of the Biosyent share sale, that were up even more than Biosyent. I think this strategy helped to reduce post-sale remorse and lessen the emotional weight of the $6.50 anchor.
I hope this article has improved your awareness of the anchoring bias. Hopefully in the future these strategies will help boost your immunity to the anchoring bias and lower your error rate when it comes to buying and selling stocks. What strategies do you use to reduce the effects of the anchoring bias?
(Thanks to TMF DMC crew for some of the original ideas for this article as well as Meredith B for her insights and feedback).