Imagine it’s the mid-1990s and an investor pays $100 per share to invest in a maker of phone pagers. The price is a historical high, but the buyer believes this is a solid investment in a useful technology. Then mobile phones take off and the internet bubble bursts, rocking the stock market. Demand for pagers shrivels and the share price drops to $35.
But the investor refuses to sell. In his mind, the stock is still “worth” around $100. Given the dramatic change in the competitive landscape, that price is no longer a relevant benchmark. So why stick to it?
This is an example of a psychological phenomenon known as “anchoring bias,” and it can have a big impact on your investments. Here’s how it works.
When people need to estimate the fair value of something, they usually start with some initial figure. Then, as they gather additional information that might affect their assessment of the value, they should adjust their estimate appropriately. The trouble is that many people stay anchored to an earlier estimate that may no longer be relevant.
In our example, the investor holds onto a stock whose value has dropped because he’s focused on an arbitrary price level that doesn’t reflect the new conditions. But this bias isn’t limited to the downside. It can also occur when a stock rises unexpectedly. An investor who bought a stock at a historical low might be tempted to sell immediately after a slight rise. But is the historical low a relevant benchmark? What if the stock is poised for a new uptrend?
How do you fight this bias?
Ask yourself questions that may reveal an anchoring bias. Am I making an assessment based on rational, objective analysis? Am I clinging to an unrealistic price—whether it’s last year’s market levels, a previous high or the purchase price—which may not have anything to do with the stock’s future course?
Then it’s time to dig deeper. For example, you could analyze the underlying company’s fundamentals—look at its financial statements, management and competitors and other factors—to help determine a stock’s value. You could also look at Schwab Equity Ratings for a list of stocks that we believe will outperform or underperform the market during the next 12 months.
The point is not to fixate on a singular data point to the exclusion of all other information.