Anchoring bias is a cognitive prejudice whereby people tend to rely on a specific piece of information to decide on the exclusion of others.
In personal finance, this is when someone considers one factor or detail to make an investment decision while disregarding others. This particular factor, which influences the decision of the investor is known as the anchor.
Because the investor relies heavily on the anchor to determine whether or not a particular investment is a good choice for their investment portfolio, this kind of behavior is termed anchoring bias.
Let’s say you want to start an investment portfolio made up of stocks. You hear that tech stocks are the best to buy because of their huge price pains, when compared to other sectors like utilities or industrials. Without carrying out due diligence, you decide to invest in tech stocks.
However, a careful investigation would have revealed that tech stocks are also volatile.
Many of them underperform in poor economic cycles because their stock prices are based on future earnings rather than present valuations. On the flip side, utilities and industries are more resilient to economic shocks and are dividend aristocrats which could compensate for the lack of share price appreciation.
The rise of meme stocks could also be used to describe anchoring bias.
Lots of retail investors poured into meme stocks like GameStop and AMC due to the buzz generated on social media platforms like Reddit without conducting fundamental analysis.
Any investment decision which is made from only one factor to the exclusion of other factors is an example of anchoring bias.
Anchoring bias can affect your investment behavior and prevent you from selecting the best investments for your portfolio. The following are more concrete ways that this investment bias may affect your behavior habits.
When you narrow in on a single aspect, it's simple to overlook the fundamentals of the investment you're thinking about.
In other words, you can tend to base your assessment of an asset's fair value on its market price rather than its basic markets. The optimal technique for making an investment decision might not be this.
Because you are investing with your emotions rather than hard facts, anchoring bias can sway you to make less-than-ideal financial decisions by anchoring bias.
Due to this investment bias, you can find yourself holding onto an expensive asset longer than is appropriate. On the other hand, you can fail to recognize an undervalued investment because you were preoccupied with its market price.
Basing your investment decisions on anchors reinforces other types of investment biases.
For instance, it can render you susceptible to confirmation bias, which is the propensity to seek out facts and statistics that support your preconceptions. Additionally, anchors may contribute to disposition bias, which is the practice of selling shares whose price has climbed and held onto shares whose value has decreased.
There are key strategies you can use to avoid anchoring bias.
Having an abundant mindset calms your nerves and enables you to avoid knee-jerk reactions to investing.
Rather than worry about a lack of opportunities, an abundant mindset makes you believe that there are lots of opportunities if you know how to look.
As such, you tend not to follow the bandwagon, but trust in your abilities to make the right decisions. This makes you trust in your analyses rather than the opinions of 'experts' or influencers on social media.
Being in the present can make you more financially conscious and mindful.
By doing so, you begin to notice how your emotions and feelings can sway your decision-making. This makes you a more disciplined investor as you would be able to separate your emotions from logic when making investment decisions.
By having a set of metrics or checklists to look out for when picking stocks, you can ensure that you stick to what's important when choosing stocks.
For example, using fundamental factors such as industry forecast, balance sheet, free cash flow, and dividend yield to make investment decisions enables you to avoid emotional biases which could hurt your portfolio in the long term.
Using checklists also ensures that you stay on track and do not deviate from your investing philosophy.
Clearly defining your investment goals is another way to avoid anchoring bias.
Ask yourself what you intend to achieve with your investments 10 or 20 years from now. This provides a roadmap of how to go about your investments and also sets boundaries on the type of assets you would invest in, and those you would not.
Writing your investment goals can also serve as a reminder when the market seems not to be going your way and you are tempted to follow the bandwagon.
Mental models are toolkits that enable us to process information and make objective decisions faster.
Legendary investor Charlie Munger popularized the use of mental models in making financial decisions. Mental models such as circle of competence, inversion, or Occam's Razor have been used by successful investors like Warren Buffett and Peter Lynch to make investment decisions.
Mental models enable you to cut through the mass of confusion and get to the bone of the matter.
Conducting due diligence in an investment before making a decision is one of the ways to beat anchoring biases.
Due diligence is the investigation conducted on a company or asset to ascertain its financial health or viability before an investment decision is made. Through due diligence, you uncover the fair value of an asset and can forecast to a reasonable extent its future performance based on fundamentals.
This enables you to dispel notions of anchoring bias and base your investment decisions on what may move the asset price rather than emotions or sentiments.
Due to the way human nature is wired, it is almost impossible to avoid anchoring bias.
As such, rather than avoid it, learn to embrace it, but to your own benefit. You can deliberately make your brain anchor relevant information before you make financial decisions.
For example, you can expose your brain to the most important or relevant information first, before you view less important or relevant ones. Or you could read up information that does not agree with your investment thesis first, before reading those that agree with your thesis.
The best strategy for overcoming the anchoring bias is to actively monitor your actions and spot the anchors that are most likely to drag you down.
You can avoid anchors that negatively affect your investment patterns by being objective and taking a practical approach to investing. It takes some practice, but over time, you get better at avoiding this investment bias.
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