Mar 20, 2009|
Why do investors make unreal forecasts?
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."
More Views on News
Jun 10, 2017
Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.
Aug 16, 2017
All across the country, the old gods become devils. New, gluten-free gods take their places...
Aug 16, 2017
And what it has in common with beating the stock market too.
Aug 16, 2017
Ensure your financial Independence, and pledge to start the journey towards financial freedom today!
Aug 14, 2017
Last week's correction is making a number of Super Investor stocks look a lot more attractive...
More Views on News
Aug 7, 2017
The data tells us quite a different story from the one the government is trying to project.
Aug 4, 2017
The small-cap space is full of small players that are clear proxies to great growth stories and Indian megatrends.
Aug 8, 2017
Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...
Aug 12, 2017
The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.
Aug 7, 2017
Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...
Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement. LEGAL DISCLAIMER:
Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here
. The performance data quoted represents past performance and does not guarantee future results.SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.
Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: firstname.lastname@example.org. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407