The Folly of Anchoring in Stock Trading

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The Folly of Anchoring in Stock Trading

If you are like many investors, then one of the metrics you use to gauge whether or not to purchase a company’s stock is based on taking a glance at the company’s price on a chart and seeing how their price has fluctuated over some past increment of time. There’s a certain rush that comes when you see a chart-based opportunity while performing some stock trading analysis that involves a graph that, for the most part, is at an appreciating 45 degree angle and has been appreciating that way for quite some time. The urge to buy stock in a positively moving company like that seems to make intuitive sense because a price that has been moving upward in the past should continue to do so in the future – Right?

In psychology there is a concept known as the cognitive bias that is used as a way to describe a number of patterns when we as humans fail at using rational judgment. Many of them have fancy names like, “Hyperbolic Discounting,” and “Irrational Exuberance,” but one in particular we need to focus on as stock traders analyzing charts is known as Anchoring. Anchoring is the bias involved when a person goes about analyzing a situation and relies too heavily on one piece of information over the rest of the available information. Of course when this is applied to stock trading 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 who is using anchoring would say that both are good investments and that you should put money in either choice because anchoring has caused them to devalue all other information like the financial statements, their ratios, and other quantitative measures that would help to paint a much better picture of the state either company is in, and holding most of the value that their decision is based on in the initial first piece of information given to them in the charts.

Making financial decisions without knowing that this cognitive bias exists and that we are all especially prone to make intuitive decisions based on it could result in a personal travesty in your brokerage account. For every drop of 50%, you will have to make that difference up by having your investments increase by 100% – Not a very easy task – In other words if you have a $10 stock that drops 50% to $5, you would have to double your $5 investment, a 100% gain, in order to be back at your original $10.

Stock 1 ends up continuing on to increase in value up to today’s date, and we all know the company as Apple. Stock 2 continues into another appreciative cycle and then drops quickly midway through 2011. The lesson to be learned is that even though both companies share similar chart progressions, you cannot limit your analysis to charts alone, and have to know when you are fooling yourself with a cognitive bias.

Stock 1: Apple

Stock 2: Agilent Technologies