Why do investors make unreal forecasts? - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

Why do investors make unreal forecasts?

Mar 20, 2009

People broadly use two approaches to arrive at decisions - conscious and sub conscious. Under the conscious approach, we evaluate various alternatives in a deliberate manner. Under the subconscious approach, we rely on our emotions to evaluate the alternatives automatically. It might seem surprising, but we take the subconscious route for most of our decisions. There are two good reasons for that - speed and efficiency. Our ancestors were often faced with life and death situations where fast decision making was the key to survival. The thoroughly analytical and slow cave man would be a tiger's favorite lunch. In addition, ordinary living involves many routine activities. Evaluating all the alternatives would consume too much brain power and would be an inefficient use of our mental resources.

However, the subconscious decisions can also put us into trouble. Behavioral economists study where our subconscious decisions tend to be wrong. They have named them 'biases'. In this article, we shall examine an important bias called 'anchoring'.

What is Anchoring bias?
In a famous study that illustrates the effect of anchoring, subjects were asked what percent of African countries were in the United Nations. In each case, a number between 0 and 100 was provided as an initial value by spinning a wheel in the subject's presence. The subject was then asked if this was too high or too low, and what adjustment needed to be made. Despite the fact that each of the subjects knew that the initial value had been determined randomly, there still tended to be a bias toward the initial value.

Examples of Anchoring bias

  • In shopping, buyers are influenced by arbitrarily posted initial prices.

  • In earnings forecasts, analysts are biased towards the previous quarters' data.

  • In valuations, investors are biased towards currently prevailing prices. At markets levels of 21,000 anchoring prevents investors from evaluating the possibility of 8,000 levels.

  • In portfolio management, investors are anchored to the initial purchase price of a stock. People say to themselves, "I'll sell the stock only if it rises back to what I paid for it". As a result, investors tend to sell their winners too soon and hold on to their losers too long.

Avoiding the Anchoring bias in stock picking

  • Admit: Realise the presence of the inherent anchoring bias in our decision making.

  • Focus on the business: Since we cannot avoid anchoring entirely, chose the right anchors. While evaluating the value of a stock, focus on the business and not merely the stock price. As Warren Buffett says, "I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful."

  • Double check the assumptions: Examine if one is anchored to any illogical values while making your valuation assumptions. For example, one should be careful about getting anchored to the latest EPS if it is the peak number in the past several years. While assigning an earnings multiple, one should be careful about getting anchored to the prevailing conditions. Warren Buffett once said, "I don't want to know the price of the stock prior to my analysis. I want to do the work and estimate a value for the stock and then compare that to the current offering price. If I know the price in advance it may influence my analysis."


Equitymaster requests your view! Post a comment on "Why do investors make unreal forecasts?". Click here!

  

More Views on News

What Do the Charts Say About Buying Smallcaps Now? (Fast Profits Daily)

Sep 18, 2020

Everyone seems to be excited about buying smallcaps now...but is it the right thing to do? What do the charts tell us? Find out in this video...

Sundaram Bluechip Fund: Will Hold the Stable Horses (Outside View)

Sep 18, 2020

PersonalFn briefly outlines the newly launched NFO note HSBC Corporate Bond Fund.

Wait! Don't Chase Smallcaps Now (Profit Hunter)

Sep 18, 2020

Let the markets take a breather before you jump in.

How Much Money Do You Need to Be a Professional Trader? (Fast Profits Daily)

Sep 17, 2020

In this video I'll answer a question I get asked often: How much capital do I really need to trade the markets for a living? Let's find out...

A Contrarian View on Whether You Should Load Up on Small Caps podcast (Views On News)

Sep 17, 2020

Rahul Shah discusses whether the SEBI circular is the perfect time to start investing in good quality small caps

More Views on News

Most Popular

Benjamin Graham Deep Value Stocks

The insights from a man who pioneered arguably the most successful form of investing there is.

How the 8-Year Cycle Can Help Identify Multibaggers (Fast Profits Daily)

Sep 11, 2020

This is how you can apply the greed and fear cycle in the market to pick stocks.

Why am I Recommending Caution? (Fast Profits Daily)

Sep 9, 2020

This is why I have changed my short-term view on the market.

This Could Be the Best September for Auto Stocks (Profit Hunter)

Sep 11, 2020

Here's why I think this month could be a great for auto stocks.

Why We Picked This Small-cap Stock for Our Hidden Treasure Subscribers (Profit Hunter)

Sep 17, 2020

This leading household brand will profit big time in a post covid world.

More

Covid-19 Proof
Multibagger Stocks

Covid19 Proof Multibaggers
Get this special report, authored by Equitymaster's top analysts now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Sep 21, 2020 09:37 AM

MARKET STATS