When it comes to making financial decisions, we all like to think we’re rational creatures who make reasonable, informed choices. Unfortunately, this isn’t always the case. Take shopping, for instance. Advertisers and business owners are well aware that purchasing behavior doesn’t always depend on customers’ rational cost-benefit analyses. In fact, much of their profits rely on the exact opposite.
One prominent irrational process sellers rely on is our tendency to fixate on numbers, even if they don’t affect the prices we pay for items. When a cashmere sweater is on sale for $400, for example, most consumers will fixate on the $600 they’re “saving” off its $1,000 listing price, while ignoring the final bill.
This phenomenon is known as the “anchoring effect.” It’s a well-documented cognitive bias that causes us to rely too heavily on one sliver of information about an event. Once that “anchor” is set in our minds, we subconsciously filter out any other data that should affect our decision, no matter how important it is.
This bias’s effects aren’t limited to discount shopping, either. It can also be incredibly costly when it comes to investing.
In the short-term, there is no guarantee that an investment will rise or fall in value in the future. Over the course of days, weeks, or even months, an equity’s price could soar, yet there’s no promise that trend will continue.
When the anchoring effect rears its ugly head, investors throw their long terms goals out the window and instead focus on these slim slices of recent performance. This leads to concentrated bets in the markets, and selling low or buying high is usually the result.
For example, emerging market equities had double-digit performance between 2004-2007. Investors who became anchored on these returns (and ignored their historical, long-term performance) would be tempted to move all their wealth into that market. By following their emotions they’d be sorely disappointed, to say the least, when that same market saw -44% returns the next year.
Wise investors are always mindful of their long-term goals on the horizon, and they know that the biggest threat to those objectives is emotional, short-term bets in the market.
Want to learn more about avoiding the anchoring effect in investing?
At LexION Capital, you can be invested in a well-diversified portfolio that will strictly focused on your long-term goals and needs. We solely look on the data, and avoid concentrated bets or emotional volatility to avoid the anchoring effect and other psychological biases.
