In my previous post, I began writing about cognitive biases. There are a number of cognitive biases that come into play in investing. The first one we examined in the post here was confirmation bias. This is the tendency to seek out information that confirms our existing view and reject information that might refute it. In this post, I’ll take a look at two additional biases — anchoring and recency bias.
But first, as a quick refresher, cognitive biases stem from heuristics, or mental shortcuts we take to arrive at decisions quickly. Such shortcuts are often necessary as we don’t have the time to go through an arduous process to reach each decision. The problem is that in certain situations, these shortcuts can systematically lead us astray, and in these situations the shortcuts are known as cognitive biases.
Anchoring is the tendency to base our thoughts and beliefs on a specific point of reference that may have little or nothing to do with the situation at hand. Kahneman and Tversky, two psychologists who pioneered the concept of cognitive biases, conducted a study in the late 70s in which they spun a wheel with the numbers 1 through 100 in front of test subjects. They then asked those subjects the completely unrelated question of what total percentage of U.N. membership was accounted for by African countries. The end result was that the lower the number that appeared on the wheel, the lower the average estimate provided by the subjects.
In investing, anchoring takes many forms, among the most common of which is using the 52 week high or low price to determine if a stock should be bought or sold. Another tendency we often find is to anchor to the price paid for a stock. It’s not at all uncommon to hear an investor say that they want to wait to sell a stock when it gets back to the price they paid for it1. As the old saying goes, the market does not care what you paid for a stock, and furthermore, tying up money in a stock means less capital is available to invest in other - perhaps better - stocks.
Another key bias, recency bias, is the tendency to give disproportionate weight to recent events and discount information from the more distant past. We, in effect, assume that we can draw a straight line from the present time to the future, even if such projections would be extremely unlikely. At the depth of the economic crises, many assume hard times will continue indefinitely while at the height of expansion, the notion that anything could go wrong is overlooked. Recency biases helped drive the dot-com bubble and it played a role in the thinking of many who cashed out as the market bottomed in the most recent downturn.
So how do we as investors guard against the biases? The most useful step is to try to recognize when the biases might be coming into play. For anchoring, ask yourself why you might be wedded to a specific value or price. If you determined your target price through an objective, quantifiable methodology, you’re likely on solid ground. To avoid recency bias, look to a broader historical context. Often the broader the timeframe you use - assuming accurate historical data is available - the better.
- We would note that in this particular instance, anchoring isn’t the only cognitive bias playing a part here. That’s not unusual as multiple biases often come into plan in a particular situation. ↩