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Flashcards in Key Concepts Deck (25):
1

Anchoring

Just as a house ought to be built on a good, solid foundation, so too should our ideas and opinions be based on relevant, correct facts. Unfortunately, this is not always the case. The concept of “anchoring” refers to the tendency we have to attach (or “anchor”) our thoughts to a reference point—even though it may have no logical relevance to the decision at hand.

Anchoring may sound counterintuitive. Nonetheless, it is prevalent in many situations and particularly in those in which people are dealing with concepts that are new.

2

Diamond Anchor

One common example of “anchoring” is the conventional wisdom that a diamond engagement ring should cost about two months’ worth of salary. This “standard” is in fact an example of highly illogical anchoring. It’s true that spending two months of salary can serve as a benchmark when buying a diamond ring, it is completely arbitrary and irrelevant as a reference point. In fact, it may have been created by the jewelry industry in order to maximize profits.

Many individuals buying a ring cannot afford to spend two months of salary on this expense, on top of other necessary expenses. As a result, many people go into debt in order to meet the “standard.” In these cases, the diamond anchor can take on a new meaning as well, as the prospective ring buyer struggles to stay afloat in a sea of rising debt.

In theory, the amount of money spent on an engagement ring should be dictated by what a person can afford. In practice, though, many individuals anchor their decision on the irrational two-month standard, revealing the power of anchoring

3

Academic Evidence

It’s true that the two-month standard in the diamond ring example above does sound relatively plausible. Nonetheless, academic studies have shown the anchoring effect to be so strong that it also takes place in situations where the anchor is completely arbitrary and random.

A 1974 paper by Kahneman and Tversky entitled “Judgment Under Uncertainty: Heuristics And Biases” shows the results of a study in which a wheel containing the numbers 1 through 100 was spun. Subsequently, subjects were asked whether the percentage of U.N. membership accounted for by African countries was higher or lower than the number on the wheel. Following that, the subjects were asked to provide an actual estimate of this figure. Tversky and Kahneman discovered that the random anchoring value of the number on which the wheel landed (which is completely unrelated to the question) nonetheless had an anchoring effect on the answer that the subjects gave. For instance, if the wheel landed on 10, the average estimate given by the subjects was 25%, while if the wheel landed on 60, the average estimate was 45%. In both instances, the random number on the wheel inadvertently drew subjects’ estimates closer to the number they were shown, in spite of the fact that it had absolutely nothing to do with the question at hand.

4

Investment Anchoring

Anchoring is a phenomenon that occurs in the financial world, too. Investors sometimes base their decisions on irrelevant figures and statistics. As an example, some investors invest in the stocks of companies that have dropped considerably over a short span of time. These investors are likely anchoring on a recent high point for the stock’s value, likely believing in some way that the drop in price suggests that there is an opportunity to buy the stock at a discounted rate.

While it’s true that the overall market may cause some stocks to drop significantly in value, thereby allowing investors to capitalize on short-term volatility, what is perhaps more likely is that a stock which has dropped in value in this way has seen a change in its underlying fundamentals.

For instance, imagine that XYZ stock had strong revenue over the past year, contributing to a share price rise from $25 to $80. In recent weeks, one of the company’s major customers, who contributed to 50% of XYZ’s revenue, decided not to renew its purchasing agreement with the company. As a result, XYZ’s share price drops from $80 to $40.

Investors who anchor to the previous high of $80 may erroneously believe that the stock is undervalued at $40. In this case, though, XYZ is not being sold at a discount; in fact, the drop in share value reflects a change in fundamentals (in this case, loss of revenue from a major customer). Investors who buy in at $40 believing the stock is valued at $80 are thus victims to the anchoring phenomenon

5

Avoiding Anchoring

The best way to avoid anchoring in your investment practices is to engage in rigorous critical thinking. It’s best to be careful about the figures you utilize to evaluate a stock’s potential. The most successful investors don’t base their decision on just one or two benchmarks. Rather, they evaluate each company from a variety of perspectives in order to derive the truest picture of the investment landscape at hand.

6

The Different Accounts Dilemma

Consider this example, which is designed to illustrate the importance of different accounts as related to mental accounting: you have set for yourself a lunch budget for each week and you are purchasing a $6 sandwich for lunch. As you go to buy the sandwich, one of the following events takes place: 1) you find that you have a hole in your pocket and have lost $6; or 2) you buy the sandwich, but as you go to take a bite, you trip and the sandwich falls on the floor. In either case (assuming you still have enough money), does it make sense to buy another sandwich? (To read more, see The Beauty Of Budgeting.)

Taken logically, the answer to both scenarios should in fact be the same, as it relates to your total weekly lunch budget. In actuality, though, many people would behave differently depending upon the scenario and as a result of the mental accounting bias. For that reason, many people in the first scenario would go ahead and buy another sandwich based on the feeling that the lost money was not part of the lunch budget, as it had not yet been spent or allocated to that particular account.

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Different Source, Different Purpose

A related aspect of mental accounting suggests that people tend to treat money differently depending upon the source of that money. “Found” money, including tax refunds and work bonuses as well as gifts, tends to be spent more freely than money earned through normal paychecks. Again, logic would suggest that these monies should be treated in the same way, but real world scenarios show otherwise.

8

Mental Accounting in Investing

People also tend to experience the mental accounting bias in investing as well. For instance, many investors divide their investments between safe portfolios and speculative ones on the premise that they can prevent the negative returns from speculative investments from impacting the total portfolio. In this case, the difference in net wealth is zero, regardless of whether the investor holds multiple portfolios or one larger portfolio. The only discrepancy in these two situations is the amount of time and effort the investor takes to separate out the portfolios from one another.

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Avoiding Mental Accounting

For investors looking to avoid the mental accounting bias, it’s crucial to remember that money is fungible; regardless of its origins or intended use, all money is the same. Keeping this in mind allows investors to cut down on frivolous spending of “found” money, to avoid wasting time separating out accounts, and so on.

For many investors, the practice of maintaining money in a low- or no-interest account while also carrying outstanding debt remains a common practice. In many cases, the interest on this debt will erode any interest you could earn in a savings account. It’s important to have savings, but in many cases it is more rational to forgo some of that savings in order to pay off debt.

10

Confirmation Bias

Most of the time, whether we realize it or not, we go into many types of interactions with a preconceived opinion of some type. During a first encounter, it can be difficult to shake these opinions, as people tend to selectively filter and pay more attention to information which is in support of their opinions as they simultaneously either ignore or rationalize the rest of the information. This selective thinking impacts people in many different ways, and it is known as a confirmation bias.

Confirmation biases in investing suggest that an investor is more likely to look for information that is in support of his or her idea about an investment than he or she is to find data which contradicts it. Because we take in these types of information differently, we’re often subject to faulty decision making as a result of one-sided information which skews our frame of reference. Investors tend to have an incomplete picture of an investment situation because of confirmation bias.

As an example, consider an investor who hears about a particularly hot stock from an unverified source. That investor may conduct research on the stock in order to “prove” that its supposed potential is real. In this case, the investor finds plenty of positive information which helps to confirm his bias (this might include growing cash flow or a low debt/equity ratio). At the same time, he is likely to gloss over or ignore major red flags, such as a loss of critical customers or dwindling markets for the company.

11

Hindsight Bias

In hindsight, many events seem very obvious. From a psychological standpoint, we may experience hindsight bias as a result of a human need to find order in the world; we create explanations which allow us to believe that events from the past were predictable. Hindsight bias and the ways of thinking wrapped up in it are not necessarily bad, but they can sometimes lead investors to find erroneous “links” between the cause and the effect of an event, thereby oversimplifying the situation and making poor decisions in the future.

Take an example of individuals who believe that the technology bubble of the early 2000s was obvious. The same kinds of hindsight bias can be found for essentially any historical bubble, including the tulip bubble from the 1630s. In each case, this represents a clear example of a hindsight bias: if the information about a bubble had truly been obvious, it’s likely that investors would not have bought in, and the bubble would not have burst. (To learn more, read The Greatest Market Crashes.)

Hindsight bias can lead investors down the dangerous path toward overconfidence. If an investor grows overconfident, he or she maintains an unfounded belief that he or she possesses superior stock-picking or investing abilities. Inevitably, this ends up leading to damaging financial decisions if allowed to unfold over a long period of time.

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Avoiding Confirmation and Hindsight Bias

Confirmation and hindsight biases are tendencies that we have to focus on information that confirms some pre-existing thought, or to generate an explanation for a past event which makes it seem inevitable or obvious. There are numerous problems with these biases, but one of the most important to keep in mind is that the fact of being aware that we maintain confirmation and hindsight biases is not sufficient to prevent us from having them. For that reason, investors are encouraged to find someone to act as a “dissenting voice of reason.” If forced to defend your investment decisions and viewpoints from a contrary opinion, you’re more likely to see holes in your arguments

13

Gambler’s Fallacy in Investing

In many situations, investors can fall prey to the gambler’s fallacy as well. As an example, some investors hold that they should sell out of a position if it has gone up over several trading sessions. The thinking behind this is that the position is unlikely to continue to increase. On the other hand, some investors might hold on to a stock that has fallen for several consecutive session because it seems like it’s “time” for the stock to pick back up. There are other factors at play, and the situation is more complicated than the flip of a coin, but this line of thinking is a reflection of the gambler’s fallacy nonetheless. (For more, see Five Mental Mistakes That Affect Stock Analysts).

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Avoiding the Gambler’s Fallacy

To avoid the gambler’s fallacy, investors should remember that the odds of any specific outcome happening on the next chance of an independent event is the same, regardless of what preceded it. This applies in the stock market as well as in the illustrative examples above: buying a stock because you believe the prolonged trend is likely to reverse at some point soon is an example of irrational behavior. Rather, investors should look to sound fundamental and/or technical analysis in order to predict what will happen with a trend.

15

The Dotcom Herd

prominent example of herd mentality in the financial and investing worlds was the dotcom bubble in the late 1990s. Venture capitalists and private investors made frantic moves to invest huge amounts of money into internet companies, in spite of the fact that many of those dotcoms didn’t have business models that were financially sound. The reason many investors moved their money in this way likely has something to do with the reassurance they received from seeing so many other investors do the same thing. Critics of the cryptocurrency boom of recent years suggest that a similar phenomenon may be taking place in that space. (For more, see How to Find Your Next Cryptocurrency Investment)

We’re all subject to herd mentality, even financial professionals. The primary goal of a money manager is to adhere to an investment strategy in order to maximize a client’s wealth. These clients may exert pressure upon money managers to “buy in” to new investment fads as they come about. A wealthy client may hear about an investment gimmick which is gaining popularity and then inquire with a money manager about whether that manager employs a similar strategy. Money managers thus feel pressure to follow general trends

16

The Costs of Being Led Astray

In many cases, herd behavior is not a sound or profitable investment strategy. Investors who are easily swayed by the herd tend to buy and sell assets frequently as they chase the latest investment trends. These investors tend to free up as much investment capital to put all of their money into the latest sector, company, or strategy, switching when the next fad comes along.

A downside to this type of behavior is that the frequent buying and selling tends to incur a substantial amount of transaction costs, eating away at potential profits. That’s to say nothing of the rationality of focusing one’s investments so densely in one area at a time, as well. It is extraordinarily difficult to time trades such that an investor enters a position when the trend is starting. Most herd investors only find out about the latest trend after other investors have taken advantage of it, and the strategy’s potential for generating wealth has likely come and gone

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Avoiding the Herd Mentality

All investors feel some temptation to follow the latest investment trends. However, investors who steer clear of the herd and maintain their own independent strategies and investment principles are likely to avoid the heartbreak that can come with being involved in an investment trend gone wrong. The best advice is to always do your homework before buying in to any trend. (For related reading, see How Investors Often Cause The Market's Problems.)

18

Overconfidence in Investing

Overconfidence can be harmful to an investor’s ability to pick stocks over the long term. A 1998 study entitled “Volume, Volatility, Price, and Profit When All Traders Are Above Average,” written by researcher Terrence Odean, illustrates this. The study found that overconfident investors typically conducted more trades as compared with their less-confident counterparts.

Perhaps unsurprisingly, overconfident investors believed that they were better than others at picking the best stocks and times to enter or exit a position. Odean also found that traders conducting the most trades tended, on average, to actually receive yields significantly lower than the market. (To learn more, check out Understanding Investor Behavior.)

19

Winners and Losers

Behavioral finance theorists Werner De Bondt and Richard Thaler released a 1985 study in the Journal of Finance called “Does the Market Overreact?” In their paper, the two researchers explored the returns on the New York Stock Exchange over a three-year period. From the stocks they analyzed, De Bondt and Thaler separated out the 35 top performing stocks into a “winners portfolio” and the 35 lowest performing stocks into a “losers portfolio.” The study tracked each portfolio’s performance as compared with a representative market index over three years.

As it turns out, the losers portfolio actually beat the market index consistently. On the other hand, the winners portfolio consistently underperformed the market. Over the three-year period, the cumulative difference between the two portfolios was nearly 25%; put differently, the original “winners” tended to become “losers,” and vice versa.

20

availability bias

For losing stocks, investors overreacted to negative news, thereby driving the stocks’ share prices down artificially and disproportionately. Over time, though, it became clear that this pessimism was outsized, and the losing stocks actually began to rebound as investors realized that the stocks were underpriced. The same is true in reverse for the winners portfolio, as investors eventually understood that their initial enthusiasm was overblown.

Part of the reason for this overreaction has to do with the availability bias. According to this bias, people tend to weigh their decisions more heavily toward recent information. New opinions thus become biased toward the latest news. (For more, see How Cognitive Bias Affects Your Business)

Availability bias can creep into our lives in subtle ways as well as significant ones. For example, imagine that you see a car accident along a stretch of road that you drive on regularly during your commute to work. It’s likely that you’ll be more cautious on that stretch of road, at least for a few days after the accident. You may be inclined to behave in this way even if the level of danger on the road has not changed at all; seeing the accident caused you to overreact. However, over time, it’s likely that you’ll regress to your previous driving habits

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Avoiding Availability Bias

We are all subject to availability bias and overreaction in various ways, and it can be difficult to keep those things in check. One of the ways to do so, however, is to work on retaining a sense of perspective over the long term. It can be easy to get caught up in the latest news, but short-term investment approaches rarely yield the best results. You are likely better served by thoroughly researching your investments so that you can accurately assess the impact of the daily news cycle without being likely to overreact in the short term.

22

prospect theory.

Prospect theory holds that people tend to value gains and losses differently from one another, and, as a result, will base decisions on perceived gains rather than on perceived losses. For that reason, a person faced with two equal choices that are presented differently (one in terms of possible gains and one in terms of possible losses) is likely to choose the one suggesting gains, even if the two choices yield the same end result.

Prospect theory suggests that losses hit us harder. There is a greater emotional impact associated with a loss than with an equivalent gain. As an example, consider how you may react to the following two scenarios: 1) you find $50 lying on the ground, and 2) you lose $50 and then subsequently find $100 lying on the ground. If your reaction to the former scenario is more positive than to the latter, you are experiencing the bias associated with prospect theory.

23

Evidence for Irrational Behavior (Prospect Theory)

Kahneman and Tversky engaged in a series of studies in their work toward developing prospect theory. Subjects were asked questions involving making judgments between two monetary decisions that involved potential gains and losses. Here is an example of two questions used in the study:

1. You have $1,000 and you must pick one of the following choices:

Choice A: You have a 50% chance of gaining $1,000, and a $50 chance of gaining $0.

Choice B: You have a 100% chance of gaining $500.

2. You have $2,000 and you must pick one of the following choices:

Choice A: You have a 50% chance of losing $1,000, and a 50% chance of losing $0.

Choice B: You have a 100% chance of losing $500.

If these questions were to be answered logically, a subject might pick either “A” or “B” in both situations. People who are inclined to choose “B” would be more risk adverse than those who would choose “A”. However, the results of the study showed that a significant majority of people chose “B” for question 1 and “A” for question 2.

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Financial Relevance

Many illogical financial behaviors can be explained by prospect theory. For example, consider people who refuse to work overtime because they don’t want to pay more taxes. These people would benefit financially from the additional after-tax income, but prospect theory suggests that the benefit they would achieve from earning extra money for additional work does not outweigh the sense of loss they feel when they pay additional taxes.

The disposition effect is the tendency that investors have to hold on to losing stocks for too long and to sell winning stocks too soon. Prospect theory is useful in explaining this phenomenon as well. The logical course of action would be to do the opposite: to hold on to winning stocks in order to further gains, while selling losing stocks in order to prevent additional losses.

The example of investors who sell winning stocks prematurely can be explained by Kahneman and Tversky’s study, in which individuals settled for a lower guaranteed gain of $500 as compared with a riskier option that could either yield a gain of $1,000 or $0. Both subjects in the study and investors who hold winning stocks in the real world are overeager to cash in on the gains that have already been guaranteed. They are unwilling to take a risk to earn larger gains. This is an example of typical risk-averse behavior. (To read more, check out A Look At Exit Strategies and The Importance Of A Profit/Loss Plan.)

On the other hand, though, investors also tend to hold on to losing stocks for too long. Investors tend to be willing to assume a higher level of risk on the chance that they could avoid the negative utility of a potential loss (just like the participants in the study). In reality, though, many losing stocks never recover, and those investors end up incurring greater and greater losses as a result. (To learn more, read The Art Of Selling A Losing Position.)

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Avoiding the Disposition Effect

Avoiding the Disposition Effect

It is possible to reduce the disposition effect, thanks to a concept called hedonic framing. As an example, for situations in which you have a chance of thinking of something as one large gain or as a number of smaller gains (i.e. finding a $100 bill versus finding a $50 bill and then later finding another $50 bill), it’s best to think of the latter option. This will help to maximize the positive utility you experience.

On the other hand, for situations where you could either think of a situation as one large loss or as a number of smaller losses (i.e. losing $100 or losing $50 two times), it’s better to think of the situation as one large loss. This creates less negative utility, because there is a difference in the amount of pain associated with combining the losses and with the amount associated with taking multiple smaller losses.

In a situation you could interpret as either one large gain with a smaller loss or a single smaller gain (i.e. $100 and -$50, or +$50), it’s likely that you’ll achieve more positive utility from the single smaller gain.

Lastly, in situations that could be thought of as a large loss with a smaller gain or as a smaller loss (i.e., -$100 and +55, versus -$45), it may be best to frame the situation as separate losses and gains.

Try these methods of framing your thoughts, and you may find that they help you to experience these situations more positively. Training yourself to reframe situations in this way can also help to avoid the disposition effect.