The Folly of Anchoring in Stock Trading

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One of the metrics you use to gauge whether or not to purchase a company’s stock is based on how their price has fluctuated over time. There’s a certain rush you feel when you see a company’s value appreciating at a 45 degree angle. The urge to buy stock in a positively moving company like that makes intuitive sense because a price that’s been moving upward in the past should continue doing so – right?

In psychology, there is a concept known as the cognitive bias, used to describe patterns that develop when humans fail to use rational judgment. As stock traders analyzing company data, it’s important to know one cognitive bias in particular: anchoring. Anchoring happens when someone relies too heavily on one piece of information, often ignoring the rest. Many amateur investors make anchoring a compulsive strategy due to a lack of experience and knowledge.

These are snapshots of two different public companies that both show something close to a consistent appreciation in market valuation over the same period of time. Someone subconsciously anchoring would say both are good investments, since they’re unknowingly devaluing other key points of interest, like financial statements, ratios and other quantitative measures that might help paint a better picture.

Without knowing this bias exists, investors are especially prone to making intuitive decisions that could result in a personal travesty in their brokerage accounts. For every 50 percent drop in price, you’d have to increase your investment by 100 percent – no easy task.

In other words, if you have a $10 stock that drops 50 percent to $5, you would have to double your $5 investment, a 100 percent gain, in order to be back at your original $10.

The first stock – a little company known as Apple – continues to increase in value. The second stock, a company called Agilent Technologies, continues into another appreciative cycle and then drops quickly midway through 2011.

Stock 1: Apple

Stock 2: Agilent Technologies

The lesson here? Even though both companies share similar chart progressions, you cannot limit your analysis to charts alone. Learn to recognize when cognitive bias might be playing a role in your decision making so you invest your money properly, earning you higher returns in the long term.