Everyone has heard a mantra about first impressions and their lasting impact. That works for investors too. Because our brains thrive on recognizing patterns and the relationship one element has with another. This mental phenomena is called anchoring.
This want for your brain to resort to a reference point and “work form there” is helpful when trying to process new information. But it’s negative when trying divine the “value” of something. Traditionally investors think of an investment as being good or bad, by looking at the point where they bought it. This is anchoring, and backwards looking. Telling me where you purchased a stock tells me very little about its current value. Anchoring bias is the tendency to rely too heavily on, or anchor to, a past reference or one piece of information when making a decision. In this case, the purchase price.
Many studies work with anchoring to prove how the mind works. He’s an example:
Take the last two digits of your phone number and answer this questions:
A good bottle of wine should cost how much more or less than those two digits?
_ Your digits _ wine bid
The bias has already taken place and caused the brain to focus on the arbitrary number. The impact is done. It should come as no surprise the people with lower phone numbers bid less for the wine as a group, those with higher digits bid more. All come from an arbitrary reference point that contaminates the valuation process.
This happens a lot in investing, a person buys a stock at $10, and the other person buys the stock at $15, the stock has recently dropped from $25 to $20, the person with a $15 entry is more likely to sell then the person at $10. But both are wrong because they use the purchase price in their valuation. The $10 buys may hold too long, and the $15 buyer may sell too soon, but the valuation of the stock should be determined regardless of the entry. The bias has taken its toll on both investors.