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Cognitive biases, the anchoring bias


Cigarbutt
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Cognitive biases are pervasive in decision making and can potentially make us go astray.

 

I am reviewing (again) this topic. The reason for this post is not really for others (even if I hope it can be useful). Mainly, I find that by writing about it and putting it on a public forum for scrutiny makes me more aware of these behavioral/cognitive biases. We are (I am) heavily influenced by biases and the unrecognized ones, especially, have potential for very bad decisions (and make you lose money or opportunities) when analyzed in retrospect.

 

Anchoring bias

 

This has to do with a common tendency to focus on a specific piece of info (the « anchor ») that comes spontaneously early on in the process and that somehow is deemed to be defining in nature. Think of the price tag on an object. Our primitive brain hates uncertainty and tends to look for an « anchor ». Once that process sets in, it can become really hard to change one’s mind.

 

Obviously, in terms of evolution and survival, this type of behavior/reasoning has potential usefulness. If you meet a bear in the forest, there’s no time for scenarios analysis or probability assessment. It’s fight or flight. Our neuro-endocrine system, in fact, works well in these circumstances. However, the anchoring bias can lead us to poor investing decisions.

 

One related application of this bias comes from « forecasts » of financial variables (GDP, oil, last quarterly EPS, etc) that are derived from present conditions or very recent trends. A lot of money has been made by those who can correctly detach themselves from this type of anchor. Another potential problem comes from relative value investing : ie if the PE of comparables is such then the value of my target investment should be such. Also, our tendency to hold an investment that is trading lower when the actual intrinsic value of that investment no longer warants holding that investment.

 

A few years ago, I invested in a canadian envelope manufacturer. Bought around 4$ and sold around 4$ a few years after (this is not the way to get rich). This was a mistake. I realized after that my investment decision had been influenced (at least partly) by the fact that the IPO price was 10$ and that somehow, this issuing price meant that there was upside at 4$ when, in fact, it was no longer relevant.

 

Another way to appreciate this bias is through the conditional probability prism (Bayes’ Theorem). Obviously, this is potentially a great statistical tool that can provide « ajustments » to the initial thesis but relies on an appropriate initial or « anchor » assessment.

 

So, what to do?

 

The challenging part is that self-awareness is not enough to eliminate this bias. To control for that bias:

 

-acquiring most/all relevant data and independently coming up with a range for IV before focusing on share price.

-writing down the fundamental reasons supporting the thesis.

-listing the fundamental factors that would kill your thesis.

-participate in a forum like this one in order to have your « anchor » tested.

 

I plan to cover other biases over time. For those who feel that this is a waste of time, the last bias that I will cover will be the blind-spot bias which is the failure to notice one’s own cognitive biases.

 

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A few years ago, I invested in a canadian envelope manufacturer. Bought around 4$ and sold around 4$ a few years after (this is not the way to get rich). This was a mistake. I realized after that my investment decision had been influenced (at least partly) by the fact that the IPO price was 10$ and that somehow, this issuing price meant that there was upside at 4$ when, in fact, it was no longer relevant.

 

+1.  Great post.

 

I've done this so many times I can't even count.  I convince myself that something is cheap. I buy it, and after another few days or a week of research decide that I was fooling myself and I sell it again around where I bought it for (sometimes for a small gain or loss) then move on.  Sometimes things are cheap for a reason and the market has already figured it out even if you haven't.  I think efficient market theory is BS, but at the same time you have to admit that the market is often correct.

 

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Great idea and thread, am reading about the biases also this summer. My only hope is to know the biases and build them into a checklist that I review before making an investment decision. It helps to have a very concentrated portfolio and not make more than 1-2 decisions a year. Love this quote from Phil Fisher, which brings in my own anchoring bias to the price I first purchase a stock, which then becomes a strong anchor for valuation, and of course should not. When the investment is a mistake, holding on to that anchor price is further complicated by loss aversion bias and sunk costs bias.

 

There is a complicating factor that makes the handling of investment mistakes more difficult. This is the ego in each of us. None of us likes to admit to himself that he has been wrong. If we have made a mistake in buying a stock  but can sell the stock at a small profit, we have somehow lost any sense of having been foolish. On the other hand, if we sell at a small loss we are quite unhappy about the whole matter. This reaction, while completely natural and normal, is probably one  of the most dangerous in which we can indulge ourselves in the entire investment process. More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason. If  to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous.” 

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The trouble for me right now is this:

 

I bought a basket of (what I think are) blue chip companies with decent relative dividends (they're in my signature if you care).

 

Prices on most of them (except Nike) have gone up quite a bit (15-20+%)

 

At the same time, I constantly have money coming into my brokerage accounts (ramping up savings).

 

So here I am thinking three things:

 

-What the hell do I purchase? It's tough to keep adding to these companies when the prices have gone up relative to where I purchased them (anchoring bias)

 

-Instead of adding to these companies, should I be selling instead? Again the anchoring bias.

 

-For the one company that would be seemingly easy to buy more of (Nike - since it has decreased), instead, I am thinking "well the market must know something I don't since the price has gone down"

 

 

 

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Daniel Kahneman's book, Thinking Fast and Slow, has helped me immensely with cognitive biases and self-awareness.  Although difficult, I would argue it will be one of the best books you have ever read.

 

Among many others, I loved the idea of

 

"A reliable way to make people believe in falsehoods is frequent repetition, because familiarity is not easily distinguished from truth"

 

& believe this can also contribute to anchoring bias (especially if you're in the habit of mumbling things frequently to yourself.)

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What the hell do I purchase? It's tough to keep adding to these companies when the prices have gone up relative to where I purchased them (anchoring bias)

 

You might like www.dividendgeek.com -- it's a free signup, and when logged in you can see a page called "Check for undervalued stocks" -- he has a lot of useful information about each company's dividend, and sorts a list of companies in each sector based on how under/over valued the current stock price is (I think he is just using a DCF to establish a 'fair value', which is simplistic sure, but it's nice to just be able to look at a list and see who the 'cheap' ones are...)

 

As for defeating anchoring though... I wish I knew how. :)  I like to tell myself that just knowing about anchoring bias is a partial defense, but perhaps that's just its own kind of fallacy (Call it "Motel 6 fallacy" maybe -- I read some books about anchoring bias, so I feel smart now, but in all likelihood I'll probably keep on anchoring)

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Daniel Kahneman's book, Thinking Fast and Slow, has helped me immensely with cognitive biases and self-awareness.  Although difficult, I would argue it will be one of the best books you have ever read.

 

I just listened to the audiobook version of Michael Lewis' book "The Undoing Project" about Daniel Kahneman's life and work with Amos Tversky -- I'd highly recommend it.

 

Another great book on decision making is "How We Decide" by Jonah Lehrer.  He wrote each chapter around a compelling story, and that made the book very memorable.  I can still tell a few of those stories in detail and it's been a few years...

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Yo I 2nd RK!

 

I've anchored hard on bitch metrics in the past (historical PE, etc.)

 

Trying to ignore them until until qualitative & quantitative issues have been scanned.

 

Fixating on metrics is at least an investment thesis. The worst is fixating on your purchase price, which is irrelevant for anybody but yourself.

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Yo I 2nd RK!

 

I've anchored hard on bitch metrics in the past (historical PE, etc.)

 

Trying to ignore them until until qualitative & quantitative issues have been scanned.

 

Fixating on metrics is at least an investment thesis. The worst is fixating on your purchase price, which is irrelevant for anybody but yourself.

 

You & LC are super right here!

 

I have a really hard time paying more than my last execution price for an issue.

 

Kind of crazy, "I'm pretty confident that it'll be worth a lot more in a decade but I don't want to pay a premium above the benchmark I've established in my head."

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Yo I 2nd RK!

 

I've anchored hard on bitch metrics in the past (historical PE, etc.)

 

Trying to ignore them until until qualitative & quantitative issues have been scanned.

 

Fixating on metrics is at least an investment thesis. The worst is fixating on your purchase price, which is irrelevant for anybody but yourself.

 

You & LC are super right here!

 

I have a really hard time paying more than my last execution price for an issue.

 

Kind of crazy, "I'm pretty confident that it'll be worth a lot more in a decade but I don't want to pay a premium above the benchmark I've established in my head."

 

Or even worse is that you don't buy it at all, because after you have convinced yourself that you want to own it, you then want to wait until it is back down to the price it was when you first added it to your watchlist.  You just can't bring yourself to pay that premium, as if the universe owes you the opportunity to buy it where it was a few months ago when you first started looking at it.  Ughh.  The human brain sucks sometimes.  These are the default modes of thinking unless you consciously override them which takes some effort.

 

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Great thread and I need to read a few of these books.  It does seem like the ability to look past the price (past/present/future) and into the actual metrics of a company and what you are paying for the company is what differentiates between the best and the rest.

 

When you read the stories on Buffett's key investments they make sooo much sense because he is looking past the price and focusing on the look through earnings, moat, growth, and lastly the price you pay for all of that.

 

Fascinating.

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Guest cherzeca

for those who have read kahnemann and tversky, remember that they were the first to point out that heuristics were endemic and unavoidable.  you can overlay analysis (slow thinking) on top of heuristics (fast thinking), but you will start with heuristics.

 

there is probably noone alive who has examined this issue in the context of investing more than munger.  reading his writings will help.

 

my own view is that you need cognitive biases to form investment theses.  you need to be aware of why you are concluding as you do, and the more you think about your conclusions, i think the more aware you become as to whether your biases are helping you or hurting you.

 

after all, your thesis may be anchored with a very important piece of the puzzle, and not all puzzle pieces in an investment inquiry have the same value.

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The trouble for me right now is this:

 

I bought a basket of (what I think are) blue chip companies with decent relative dividends (they're in my signature if you care).

 

Prices on most of them (except Nike) have gone up quite a bit (15-20+%)

 

At the same time, I constantly have money coming into my brokerage accounts (ramping up savings).

 

So here I am thinking three things:

 

-What the hell do I purchase? It's tough to keep adding to these companies when the prices have gone up relative to where I purchased them (anchoring bias)

 

-Instead of adding to these companies, should I be selling instead? Again the anchoring bias.

 

-For the one company that would be seemingly easy to buy more of (Nike - since it has decreased), instead, I am thinking "well the market must know something I don't since the price has gone down"

 

Withdraw some capital & buy a house mortgage free  ;)

The portfolio will have some margin, you have incentive to use your CF to wipe it out asap, and you get paid while you're waiting (no interest on the margin you've paid off). The 'Itch' now becomes an asset.

 

SD

 

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for those who have read kahnemann and tversky, remember that they were the first to point out that heuristics were endemic and unavoidable.  you can overlay analysis (slow thinking) on top of heuristics (fast thinking), but you will start with heuristics.

 

there is probably noone alive who has examined this issue in the context of investing more than munger.  reading his writings will help.

 

my own view is that you need cognitive biases to form investment theses.  you need to be aware of why you are concluding as you do, and the more you think about your conclusions, i think the more aware you become as to whether your biases are helping you or hurting you.

 

after all, your thesis may be anchored with a very important piece of the puzzle, and not all puzzle pieces in an investment inquiry have the same value.

 

this is so much fun!

 

i cant imagine anyone not being enriched by this thought process (monetarily & personally...)

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Yo I 2nd RK!

 

I've anchored hard on bitch metrics in the past (historical PE, etc.)

 

Trying to ignore them until until qualitative & quantitative issues have been scanned.

 

Fixating on metrics is at least an investment thesis. The worst is fixating on your purchase price, which is irrelevant for anybody but yourself.

 

You & LC are super right here!

 

I have a really hard time paying more than my last execution price for an issue.

 

Kind of crazy, "I'm pretty confident that it'll be worth a lot more in a decade but I don't want to pay a premium above the benchmark I've established in my head."

 

Or even worse is that you don't buy it at all, because after you have convinced yourself that you want to own it, you then want to wait until it is back down to the price it was when you first added it to your watchlist.  You just can't bring yourself to pay that premium, as if the universe owes you the opportunity to buy it where it was a few months ago when you first started looking at it.  Ughh.  The human brain sucks sometimes.  These are the default modes of thinking unless you consciously override them which takes some effort.

 

Yes that one really sucks. The only question should be whether it's objectively cheap (enough). This is why averaging down is so much easier. I also always feel hesitant adding to positions I initiated years ago which have gone up.

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Guest cherzeca

another thing to keep in mind is the war of the heuristics

 

a common (and i think good) heuristic is to let winners run and sell losers after x% decline. another heuristic is to buy more of a cheaper stock (that x% loser) if your investment thesis is intact.

 

so you need what might be called a "rule of recognition" to choose among competing heuristics.

 

not bloody easy

 

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Yo I 2nd RK!

 

I've anchored hard on bitch metrics in the past (historical PE, etc.)

 

Trying to ignore them until until qualitative & quantitative issues have been scanned.

 

Fixating on metrics is at least an investment thesis. The worst is fixating on your purchase price, which is irrelevant for anybody but yourself.

 

You & LC are super right here!

 

I have a really hard time paying more than my last execution price for an issue.

 

Kind of crazy, "I'm pretty confident that it'll be worth a lot more in a decade but I don't want to pay a premium above the benchmark I've established in my head."

 

Or even worse is that you don't buy it at all, because after you have convinced yourself that you want to own it, you then want to wait until it is back down to the price it was when you first added it to your watchlist.  You just can't bring yourself to pay that premium, as if the universe owes you the opportunity to buy it where it was a few months ago when you first started looking at it.  Ughh.  The human brain sucks sometimes.  These are the default modes of thinking unless you consciously override them which takes some effort.

 

Yes that one really sucks. The only question should be whether it's objectively cheap (enough). This is why averaging down is so much easier. I also always feel hesitant adding to positions I initiated years ago which have gone up.

 

I love averaging down too (frequently requires enduring bad news & figuring out if it's relevant.)

 

I like to buy 1/3 & then add another 1/3 & so on until full (if the bad news sounds like noise & it really tanks after I'm full, I'll go out on a long limb with LEAP calls and as long as the idea holds water...?)

 

if it never goes down, it's all good.

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Guest jeffswaldron

Yo I 2nd RK!

 

I've anchored hard on bitch metrics in the past (historical PE, etc.)

 

Trying to ignore them until until qualitative & quantitative issues have been scanned.

 

Fixating on metrics is at least an investment thesis. The worst is fixating on your purchase price, which is irrelevant for anybody but yourself.

 

You & LC are super right here!

 

I have a really hard time paying more than my last execution price for an issue.

 

Kind of crazy, "I'm pretty confident that it'll be worth a lot more in a decade but I don't want to pay a premium above the benchmark I've established in my head."

 

Or even worse is that you don't buy it at all, because after you have convinced yourself that you want to own it, you then want to wait until it is back down to the price it was when you first added it to your watchlist.  You just can't bring yourself to pay that premium, as if the universe owes you the opportunity to buy it where it was a few months ago when you first started looking at it.  Ughh.  The human brain sucks sometimes.  These are the default modes of thinking unless you consciously override them which takes some effort.

 

Yes that one really sucks. The only question should be whether it's objectively cheap (enough). This is why averaging down is so much easier. I also always feel hesitant adding to positions I initiated years ago which have gone up.

 

I love averaging down too (frequently requires enduring bad news & figuring out if it's relevant.)

 

I like to buy 1/3 & then add another 1/3 & so on until full (if the bad news sounds like noise & it really tanks after I'm full, I'll go out on a long limb with LEAP calls and as long as the idea holds water...?)

 

if it never goes down, it's all good.

 

What kind of success have you had averaging down? It sounds good in theory, but it takes a lot of conviction.

 

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I love averaging down too (frequently requires enduring bad news & figuring out if it's relevant.)

 

I like to buy 1/3 & then add another 1/3 & so on until full (if the bad news sounds like noise & it really tanks after I'm full, I'll go out on a long limb with LEAP calls and as long as the idea holds water...?)

 

if it never goes down, it's all good.

 

What kind of success have you had averaging down? It sounds good in theory, but it takes a lot of conviction.

 

The theory is based on an anchor I set out after making a nice profit from Edwards Lifescience's back in 2013ish.

I bought x200 shares & x2 LEAP calls & the thing doubled about a year later.

Traded off the calls (LT cap gain) & nearly paid for the shares which split & doubled again (more LT cap gain.)

I didn't have this theory at the time & now recognize the anchor regarding LEAPs (thanks?)

 

Started looking for similar opportunities & still haven't found a good one (unless ESRX pays off)

 

Most of the items in my signature are only 1/3 of what I want since they haven't gone down.

Novo Nordisk made it to 2/3 but there are no long dated calls.

Apple is down to around 1/3 after I sold some (like an idiot.)

 

(all fractions represent what I own of what I'd like to own)

 

ESRX is the overhang on this theory at the moment & may not be a good comp.

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The trouble for me right now is this:

 

I bought a basket of (what I think are) blue chip companies with decent relative dividends (they're in my signature if you care).

 

Prices on most of them (except Nike) have gone up quite a bit (15-20+%)

 

At the same time, I constantly have money coming into my brokerage accounts (ramping up savings).

 

So here I am thinking three things:

 

-What the hell do I purchase? It's tough to keep adding to these companies when the prices have gone up relative to where I purchased them (anchoring bias)

 

-Instead of adding to these companies, should I be selling instead? Again the anchoring bias.

 

-For the one company that would be seemingly easy to buy more of (Nike - since it has decreased), instead, I am thinking "well the market must know something I don't since the price has gone down"

 

Withdraw some capital & buy a house mortgage free  ;)

The portfolio will have some margin, you have incentive to use your CF to wipe it out asap, and you get paid while you're waiting (no interest on the margin you've paid off). The 'Itch' now becomes an asset.

 

SD

 

Did that last year...very good point on paying it off early. Reduction of interest/mtg insurance + appreciation can be thought of as a nice dividend. Cheers :)

 

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