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Monday, December 1, 2008
Anchors aweigh or anchors away?

Study after study has shown, together with observations of actual behaviour that investors are never as rational as standard finance theory would have us believe. One observed bias is Anchoring. “This is a concept that when developing a value, individuals tend to begin by starting with a reference point, i.e. an initial default ‘anchor’,” explains Ian de Lange of Seed Investments.
“They then go through a process of fine tuning, reassessing, into a final estimate.”
This may be a function of how our brains think, i.e. use a shortcut tool to solve complex problems, by first selecting an initial reference point and slowly adjusting to the correct answer as it receives additional information.
But studies indicate that regardless of how the initial anchors were chosen, people tend to re-adjust final estimates and these are essentially then biased to the initial anchor.

Some examples of investment anchoring:
• Many investors buy a share at price of R25, watch it move ahead to a high of say R40 on positive news, but then slip back slightly to say R37. They now anchor on the high price of R40, believing that prices below this now represent a discount and possibly a buying opportunity.
• Price indices, such as the Dow at 10 000 become an anchor point.
• Forecasts or earnings upgrades tend to be anchored around percentage increases or decreases from a particular base.

For example, an analyst forecasts that a company will post a quarterly earnings of 65c/share, but the company actually posts 75c/share. The analyst then tends to raise his forecast for the next quarter’s earnings, but not by enough.
Yet another type of anchoring is when investors tend to hold onto an underperforming investment, waiting for it to get back to its original cost, so that it will ‘break even’
Examples:
1. Property valuations. Real Estate agents have used anchoring to good effect in their property valuation techniques, which centred on “comparative pricing”. By anchoring on recent area sales values, both buyer and seller, have a cognitive anchor.
This works well in a “normal” market, but the pricing error mechanism is soon seen when prices fall 25% in one year from a peak, i.e. prices push up steadily but surely, using anchoring to good effect, but they reach an extreme point.
2. Past history. Investors can become anchored to the economic state of a company or even a country. An example in South Africa is where investors anchor to the fact that Remgro is a bellwether (i.e. leading) stock. But this may not always be the case. Japan became an economic powerhouse in the 1980s and investors thought it would last for decades – it did not.

In other words, urges Ian de Lange: “At all times, investors need to take a step back and adopt a clean slate approach to their investments.”
For more information please visit: www.seedinvestments.co.za or call (021) 9144966 
 

Copyright © Insurance Times and Investments® Vol:21.11 1st December, 2008
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