It has been said that investors are irrational. It should also be said that humans are irrational, at least in the economic sense. Traditional economic theory defines an irrational being as one who is influenced by emotion and makes errors in judgments. In other words, human beings are irrational beings.
Many of these errors in judgments come from cognitive biases. Anchoring is a common bias that causes us to overweight the status quo or focus on one expected outcome. Many investors anchor to expected return (let’s say 8%), yet fail to consider the major fluctuations investors will likely experience on the way to generating an average 8% return. If the portfolio is down 18% in a given quarter, investors expecting a 8% return may be tempted to bail – because such poor performance wasn’t considered.
But anchoring also affects investors in the way they save, spend, and invest.
Despite the difficult year we have had, investors have benefited from significant wealth creation over the past decade. In fact, when we extend our time horizon even further, we see even greater wealth creation.
As our wealth increases, so does our lifestyle. We may buy a larger or nicer home. A nicer car. Take more lavish vacations. Buy higher quality clothes. Eat out more at nice restaurants. You get the picture. When wealth increases, we tend to increase our spending as we seek a higher quality of life. After a while, this new spending becomes our new normal, our new anchor. We have “anchored up.”
But what happens when markets are negative and our wealth is decreased, such as in 2022? If we “anchor up” our lifestyle in response to increased wealth, it would be rational to decrease our lifestyle in response to reduced wealth, “anchor down.” But, alas, we are not rational.
When markets and portfolios go down, investors will do just about everything EXCEPT reduce their lifestyle. Investors facing negative performance may complain, blame, get anxious, get upset, and lose sleep at night. Many will resist the idea of reducing spending and/or increasing their savings during difficult times. Ironically, these are two things within an investors control, whereas market performance is completely out of our control.
Anchors are stubborn and difficult to adjust. That’s why they are called anchors. The full name of the cognitive bias is called anchoring and adjustment. We anchor to one situation or expectation, and do not want to deviate much from that anchor. The dissonance of anchoring up (but not down) is akin to volatility. We have no problem with upside volatility, just downside. And we have no problem anchoring up, but you better not ask me to anchor my spending and lifestyle down – even though that would give me the best chance at maximizing my long-term wealth and prosperity.