As humans, we rely on anchors quite a bit. I am not referring to the same kind of anchor a boat uses to keep it in place; I am referring to psychological and mostly subconscious anchors.My Anchoring Story
Earlier this month I purchased a car. I had done quite a bit of research before purchasing the car – including looking at the various options, the invoice price of the car and dealer rebates made available to the public. And I had been pondering this for months to ensure the emotion and excitement of a big purchase did not influence my decision. But still, when it came down to making a decision, it was difficult. I was fine with the price, but the nagging feeling I had was “Am I getting a good deal?” We all want a good deal, and even more than that, none of us want to feel that we paid more than we should have. So how was I to judge if I was getting a good deal?
In this case, I used a few websites that provided a “target price” that is based on the car’s invoice price (not MSRP), any rebates or incentives at the time and allows for the dealer to make a reasonable profit. Based on the target price, I was getting a very good deal. That target price became my anchor, or reference point, to help me decide whether it was a good deal – which ultimately influenced by decision to buy.
Our Daily Anchoring
This happens in various facets of life. Whenever we get the price of a good or service that we are interested in, we first must determine if it is a good deal. Retailers help us during sales by showing us the pre-sale price and then the sale price. And many of us, myself included, may also go to the Amazon App on our phones and compare prices on Amazon with the price at the store. Amazon is my biggest source of obtaining reference points when it comes to shopping.
Investment Anchoring
These same principles influence investors. We need reference points when evaluating our investments. What if I told you that you will earn 8% next year? Would you be happy? What if the markets were up 50% next year…how would you feel? You get the point. We rely on reference points, or anchors, to help us understand if something is good or bad. And oftentimes that drives our decisions.
Another way we anchor in investing is when we take a historical return or future expected return, and that becomes our reference point. If the portfolio has historically achieved and/or is expected to return 7%, guess what our anchor is? That’s right, it’s 7%. But here is the problem. The market almost never returns exactly 7% – instead we get returns such as +20% and -15%…that over time averages to 7%. But when the market is down 15%, investors may panic because the double digit loss is not in line with the expected 7% return. And panicking often leads to making hasty and unwise decisions.
So we know our brains love to anchor. They do it in all aspects of life. It’s important when we are investing that we take this into account and instead of just fixating on the expected future return, we also want the likely range of returns to be our anchor as well. We know the portfolio value will fluctuate, so let’s not focus so much on a value that never fluctuates – instead understand and anticipate what range of returns your portfolio is likely to experience.
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