Overcoming Anchoring Bias when Investing
Investing in the stock market can be a challenging and complex process, requiring careful analysis and strategic decision-making. However, the human mind is prone to certain cognitive biases that can cloud our judgment and lead to irrational investment decisions. Mean reversion, anchoring bias, and the gambler’s fallacy are three such biases that can impact the way we process and interpret financial data. While these concepts are distinct, they share some similarities and can be related in a few ways.
In this blog post, we will explore the illusions of mean reversion and predictability, as well as the danger of relying on past prices due to anchoring bias. We will also discuss how these biases are related to emotions and can affect investment decisions. Finally, we will provide some practical tips on how investors can use objective criteria to overcome cognitive biases and make more informed investment decisions.
Illusion of Mean Reversion
Mean reversion refers to the tendency of a variable, such as “heads or tails”, to revert to a long-term average after experiencing a period of above or below-average performance. While a random variable, such as the flip of a coin, may eventually revert to its mean, this is only the case since heads and tails have an equal chance of occurring. Mean reversion does not apply to the stock market since prices are not random independent variables. The price of stocks is related to the underlying value of the companies they represent and also influenced by the wider world around us including investor sentiment, futures expectations, the value of money, and the alternative uses for capital.
As market efficiency proves, the current price of of a stock represents all known information and future expectations. History shows us that investors are not able to “time the market” with consistency, and they can only get lucky occasionally. Simply because a stock price may be higher or lower than what it was in the past is no indication of its future trajectory.
Therefore, waiting for a stock to fall in price before investing or studying past trends to determine future value highlights a anchoring bias and will hurt investment results.
Danger: Relying on Past Prices
Anchoring bias is a cognitive bias that causes people to rely too heavily on the first piece of information they receive when making decisions or forming opinions. In the context of shopping, retailers use anchoring bias to promote sale prices. They show shoppers how the current price is lower than the past price. Doing so encourages shoppers to perceive the current lower price as “a good deal”. When in fact, the current price is merely that: the current price. Whether the current price is good or bad should be evaluated based on objective criteria, not past prices.
In the context of investing, anchoring occurs when an investor uses a previous stock price as a reference point to make decisions, regardless of whether that price is truly reflective of the stock’s intrinsic value or not.
The way to avoid falling victim to such anchoring biases is to evaluate decisions based on their merits using objective criteria, not price trends.
Illusion of Predictability
Finally, the gambler’s fallacy is the belief that past events, will influence the likelihood of future events. For example, someone might believe that a coin that has landed on heads five times in a row is more likely to land on tails the next time, even though the probability of heads or tails remains 50/50 regardless of past outcomes.
The same fallacy plagues investors. Simply because one outcome has been recorded in the past should not influence decisions about the future. Instead, investors should use objective criteria to make decisions.
How Emotions Affect Investment Decisions
So how are mean reversion, anchoring bias, and the gamblers fallacy related? The connection is they all describe ways that we use our emotions to make decisions. And for investors, using our feelings, “going with our gut”, and using our instincts is a losing strategy.
Successful investors find ways to keep their emotions at bay. They use objective criteria to make investment decisions.
Overcoming Cognitive Biases in Investing
Here are four ways that investors can use objective criteria to make investment decisions:
- Establish an Investment Plan: Investors should start by developing an investment plan that outlines their investment goals, time horizon, risk tolerance, and asset allocation strategy. This plan should be based on objective criteria, such as historical performance data and financial analysis, rather than emotions or hunches.
- Focus on Fundamentals: Investors should use fundamental analysis to evaluate the underlying value of the companies they are investing in. This involves looking at financial metrics such as revenue, earnings, and cash flow to determine whether a stock is undervalued or overvalued.
- Diversify Your Portfolio: Diversification is a key strategy for mitigating risk in investing. By investing in a mix of asset classes, such as stocks, bonds, and real estate, investors can spread their risk across different types of investments and avoid being overly exposed to any one market or sector.
- Avoid Timing the Market: Trying to time the market is a common error investors make that can lead to poor investment decisions. Instead, investors should focus on building a diversified portfolio that aligns with their long-term goals and investment plan.
By using objective criteria and a structured approach to investing, investors can overcome emotional biases and make more informed and rational investment decisions. While it can be challenging to stay disciplined in the face of market volatility and uncertainty, sticking to a well-planned investment strategy can help investors achieve their long-term financial goals.