What is 'Anchoring'
Anchoring is the use of irrelevant information as a reference for evaluating or estimating some unknown value or information. In the context of investing, one consequence is that market participants with an anchoring bias tend to hold investments that have lost value because they have anchored their fair value estimate to the original price rather than to fundamentals. As a result, market participants assume greater risk by holding the investment in the hope the security will go back up to its purchase price.
BREAKING DOWN 'Anchoring'Anchoring is a behavioral bias in which the use of a psychological benchmark, rule-of-thumb or heuristic carries a disproportionately high weight in a market participant’s decision-making process. The concept is part of the field of behavioral finance, which studies how emotions and other extraneous factors, rather than rational theories and analysis, influence economic choices.
Market participants are often aware that their anchor is imperfect and attempt to make adjustments to reflect subsequent information and analysis. However, these adjustments are often nothing more than anchors of a different sort (e.g. 10% up or down) and produce outcomes that reflect the bias of the original anchors.
Consequences of Anchoring
An anchoring bias can cause a financial market participant, such as a financial analyst or investor, to reject a correct decision (buy an undervalued investment, sell an overvalued investment) or accept an incorrect decision (ignore an undervalued investment or buy/hold an overvalued investment). The anchoring bias can be present anywhere in the decision-making process, from key forecast inputs (e.g., sales volumes, commodity prices) to final output (e.g., cash flow, securities price.)
Historical values, such as acquisition prices or high water marks, are common anchors. This holds for values necessary to accomplish a certain objective, such as achieving a target return or generating a particular amount of net proceeds. These values are unrelated to market pricing and cause market participants to reject rational decisions.
Anchoring can be present with relative metrics, such as valuation multiples. A market participant using a rule-of-thumb valuation multiple to evaluate securities prices, such as X-times-EBITDA or Y-times-free cash flow, is demonstrating anchoring when they ignore evidence that one security has a greater potential for earnings growth.
Detecting and Overcoming Anchoring
Anchors, such as absolute historical values and values necessary to accomplish an objective, are not helpful, and market participants should dismiss them outright. Other anchors can be helpful as market participants deal with the complexity and uncertainty inherent in an environment of information overload. Again, awareness is important for detection, but awareness alone is insufficient. Market participants can counter the bias by identifying the factors behind the anchor and replacing suppositions with quantifiable data.