WIKIPEDIA defines "anchoring" as a cognitive bias that describes the common human tendency to rely too heavily, or "anchor", on one trait or a piece of information when making decisions.

Although such tendencies to make decisions by relying on a particular reference happens all the time everywhere, we will only discuss how anchoring affects our investment decision-making process. Only through the understanding of how our mind works can we appreciate how many times we have made the wrong decision because the mind has to "anchor" to a reference before telling us what to do.

Established in 1974
The concept of anchoring was first established by the research of Amos Tversky and Daniel Kahneman in 1974. In one of their first studies, participants were asked to guess the percentage of African countries which were members of the United Nation (UN). Participants in Group A were asked, " Was it more or less than 45%?", and participants in Group B were asked, "Was it more or less than 65%?". Participants in Group A guessed lower values than participants in Group B. Similar experiments were conducted at different times and on different subjects. The results were similar.

The two researchers came to the conclusion that peoples' decisions are influenced by the number first given to them. The number was purposely given prior to the decision to distract their judgement and confuse their thinking. The percentages given to participants in Group A and B had nothing to do with the actual percentage of African nations in UN. It is obvious that most people will use what is given to them and what is still fresh in their memory to determine how they can make use of it to come to a conclusion, even though the information may not be relevant at all.

Common anchoring bias
There are many such anchoring biases in real life.

People buying a second-hand car are more likely to pay more attention to the odometer reading and look for the mileage clocked and the year of manufacture instead of relying on the condition of the car itself.

In an auction, the bidding prices are anchored by the reference price given by the auctioneer.

In property transactions, buyers or sellers are influenced by the latest price transacted on a similar property. Buyers will quote the lowest price transacted, and sellers will refer to the highest price done. The price transacted on a particular property is influenced by many factors, depending whether the seller or the buyer is more motivated to sell or buy. The value of a specific property is also affected by the orientation, location, interior design, condition, neighbourhood, etc.

Anchoring is a well-known phenomenon in negotiation, when either party tries to bargain for the best result. Both parties will scrutinise the offers in front of them. Negotiation centres around the buyer and seller anchors. A final compromise is reached when both parties are happy that they have obtained reasonable bargains. If the initial anchors are set differently, the final settlement may not be the same. As such, the first anchor is important in influencing the final result.

Lawsuits are influenced by the initial demand made by the plaintiff. It is common for the plaintiff to ask for sky-high compensation and for the defence to scale the settlement downwards.

In a negotiated transaction, a seller who quotes a higher price tends to get a better bargain; similarly, a buyer who quotes a lower price is likely to buy at a lower-than-expected price. The price first quoted by a seller or a buyer is used as the reference quote for further negotiations. This is probably the most common tactic used by lady shoppers to bargain for a lower price — especially in a foreign land, where there is little clue as to what is the fair price of an item.

In earnings forecasts, analysts tend to compare a previous month's or previous year's results to determine whether the company has performed better or not. Such simplistic comparisons are also commonly seen in the headlines of newspapers. It is not uncommon to read conflicting news on the same set of a company's results: "Company X records lower earnings" (than last year) being reported in one newspaper, and another newspaper reporting "Company X shows improved profit" (than last quarter).

The valuation of a stock can also be made with reference to other similar stocks in the same industry. If an average stock trades at a price-earnings ratio of 12 times, the valuations of other stocks are compared with this average. An industry average is also regularly used as the anchor even though each stock has its own character, strength, management capability, corporate governance, market liquidity, etc.

Anchoring and adjustment
When making a decision, most people start with a reference point or anchor to make adjustments upward or downward to achieve an estimate which appears reasonable. Usually, once the anchor is set, there is a bias towards that anchor.

In a study, students were asked to estimate the product answer for a series of equations within a short time. The first group of students made a median estimate of 512 for "1x2x3x4x5x6x7x8". The second group of students made a higher median estimate of 2,250 for "8x7x6x5x4x3x2x1". It does not matter that both groups were wrong — the real answer is 40,320 — but the estimate of the first group of students was far lower because they started with a lower anchor and hence provided a smaller estimate. Even though the second group of students started with a higher anchor, they were still not able to appreciate the power of compounding.

Irrelevant anchor
In the above example, the students started off with the anchor (the first few numbers in the series) given to them without realising that the anchor could be irrelevant and intentionally meant to distract them.

In real life, most people use certain events or values known to them even though these facts may have little bearing on the actual answer. The events or values are usually vivid in their minds either because such happenings have a strong impact on them in the past or the events surface repeatedly recently. These events or values come automatically when called for, regardless of its relevancy. Unfortunately, such events or values end up as the anchor which becomes the first reference point of estimate.

Cost price
Anchoring bias can be a source of frustration in the financial world. It may lead to many prejudiced judgements, slanted selections and wrong decisions.

Many investors are heavily influenced by their cost of investment. It is not uncommon to hear "If the stock goes up to my cost, I will sell it" or "How can I sell now, I am losing money". Such emotional statements are not rational. The decision whether to sell a stock or not has nothing to do with the cost of investment. The market does not pay heed to the cost of an investor; the market is only interested to know the prospects and outlook of a stock. A stock which was bought at a price of RM5 will not recover to the price if the business prospects have deteriorated.

For example, a timber stock which lost its timber concession is a different stock now. A politically-linked stock will not have the same vigour after the departure of the key driver. A property stock will not show similar high margins after having fully developed its cheap landbank. The bumper profit of a stockbroking firm from a bullishly high volume will not be repeated until the next bull cycle. A company which has lost its main agency right may not be able to show similar earnings again, etc.

Many investors who buy stocks at the peak of rumours in anticipation of certain bullish news are literally stuck with high costs of purchase. When the prices plunge subsequently, they refuse to sell as they have anchored their investment based on their costs. They will wait for the price to recover their cost before selling. Such decisions are emotional and bad for rational investments based on logic and fundamentals. Investors worldwide — be they from Asia or from Europe — generally tend to hang on to losing investments. Instead of taking a small loss, they risk their investment with a higher downside when the stock price drifts lower. Some investors even wait five to ten years on the hope of recovering their cost.

On the other hand, when the stock price goes up after purchase, many investors are quick to take profits. Their anchor is the cost of purchase and not the reason why the stock price has gone up (see Chart 1).

Closing price
Daily closing prices have been used regularly as anchors. Performance of a stock in a day is made with respect to the previous day's closing price. Even though Bursa Malaysia has literally fixed the closing price at the last 15 minutes by allowing buyers and sellers to transact at that fixed price, the closing price does not truly reflect all the supply and demand condition for a share. A thinly traded stock can easily be manipulated by certain interested parties.

Newspapers will also quote the closing prices of stocks, and these are used widely as the reference by investors.

Highest price
The historical highest price of a stock has always been used as the target that an investor wants his or her stock to go to. Unless a stock continues to scale new highs everyday, most often than not the prevalent price is lower than the 52-week high price. It is not uncommon to hear investors lamenting and cursing themselves for not selling at the high (see Chart 2).

The 52-week high price becomes an anchor for many investors. After a stock comes down from the recent high, an investor who intends to sell the stock will closely monitor the daily price so that he or she will not miss the next opportunity if the stock goes back to the same high again.

Although the 52-week high price is the highest price transacted over the past one year, the price was probably there for a short moment and the quantity traded was probably limited. It is not as if the 52-week high price was holding in the market for half an hour for investors to sell. To be realistic, a 52-week high price is only a record, and only a handful of lucky investors managed to sell at the price. As such, it is not a good anchor for investors to sell at the highest price. The high of the 30-day moving average, for example, is perhaps a more practical anchor.

Certain stocks which suffer from deteriorating fundamentals will never climb back to the same old level again.

Lowest price
The 52-week low price is also a popular anchor used by many investors as a reference. In a bearish market when stock prices come under selling pressure, a stock is likely to create new lows. The lowest price could be created by a desperate seller. It could also be due to force-selling by a financier. After the selling stops and recovers, a new 52-week low price appears. The lowest price can also be due to error trades (see Chart 3).

Those who managed to buy at a 52-week low are lucky to be there at the right time and right place. Unless one is sitting in front of the computer terminal monitoring stock prices, the ability to catch the lowest price is almost impossible. For normal investors who are busy with their normal routine, buying at the lowest price is impractical. As such, buying at a 52-week low price is not a good anchor for investment purposes.

In a technical analysis, high-low-close prices are used as basic data for charting purposes. Some of these make sense — but essentially, charts try to read the market supply and demand situations.

Other financial anchors
The initial public offering (IPO) price is also a common anchor used by many investors, especially during the initial period of listing. The perception is that the promoter of the stock may not want the stock to go below the IPO price. Furthermore, those who purchased at the IPO price may not want to cut losses if the share price goes below the IPO level.

From recent listings, this theory does not hold water. Many IPOs went below water soon after listing. There are many reasons why investors who took the IPO are prepared to take a loss.

Another common anchor is par value. A stock which trades way above the par value is deemed expensive. It is not uncommon to hear a comment from investors that stock A (which trades at RM22( is more expensive than stock B (which is only RM5.35).

Other anchors used by investors include rights issue price, private placement price and NTA.

Think rationally
Knowing how our brain plays tricks on us, it is time for us to avoid falling prey to this type of bias. The awareness of such biases allows us to better manage the decision-making process, allowing us to think rationally so that the right decision is made based on fundamental information available to us. Investment decisions based on irrelevant anchors will only distort our judgements. The bottom line performance of an investment will depend more on the best decision at that point in time.

The various anchors can still be kept as reference and they should not mingle with the relevant information used for investment decision.

Ang has 20 years' experience in research and investment. He is currently the chief  investment officer of Phillip Capital Management Sdn Bhd.