Behavioural Investing: Anchoring

A building needs to be be built on a solid foundation, a theory must be built on solid arguments, and an investment decision must be built on solid analysis. However, investors often make investment decisions which are built not on solid analysis, but "anchored" on reference point. How does this impact returns enjoyed by investors? In the following paragraphs, we investigate.

Imagine that Mr. A purchased stock in company 'A' for Rs 100 per share. The stock steadily rises to Rs 150 over a period of a year. Unfortunately, as it turns out, the company derives 50% of its sales from its license of a fast-selling software product. Suddenly, the licensor decides to withdraw the license and enter the market on its own. The stock tanks as soon as the news breaks and hits 110. However, Mr. A sees that the stock is off its high of 150 and hence erroneously assumes it is undervalued, and purchases more stocks.

However, the company's fundamentals have clearly deteriorated, with no immediate hope of maintaining its earnings, unless it is able to take some radical steps. Thus, by falling victim to 'Anchoring Bias', Mr. A has compounded his loss.

Anchoring also works in another way. Since, even at Rs 110, the stock is above Mr. A's purchase price, he still has an illusory feeling that he is in the money. Hence, he continues to hold/ or even increases his position in the stock. Thus, instead of redeploying his money in a company with better fundamentals, he is continues to suffer from the consequences of his behavioural biases.