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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."

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