How Anchoring Affects Your Investments

We all have lived long enough to know one fact very well that our brain is the most important organ. If we can think and keep thinking life becomes much easier. However, we do not realize one aspect; the brain’s sole functioning is not to be our think tank. Its primary functions include protecting us. From whom? Of course the big bad world but there is one person the brain protects us from - Us! Why do we need protection from ourselves?

Ego is that part of our personality that consists of our identity. It defines who we are, our capabilities and also our limitations. If an individual faces any situation where the ego might get hurt, they create a barrier of denial or illusion. Hence, using the most powerful organ of our body, the brain, we formulate reasoning and illusion, often called a bias, which helps protects our fragile ego. These biases often referred to as “shortcuts” are quick fix solutions that we subconsciously device for ourselves. However, in the process, we are doing more harm than good. One such bias is called Anchoring.

Anchoring & Salience: Mutual Funds

You may have conjured the image of a ship on a shore which has been anchored. The ship is unable to sail and seek new lands because of the existing bondage. Anchoring works on the feature of salience. Salience refers to bits of information that investors consider to be most important and prominent. If an investor is planning to invest in Mutual Funds they anchor information that favours Mutual Funds. Investors often listen and choose to remember the parts where financial advisors praise a certain fund or stock in terms of profitability and ignore the parts where they may have spoken about the risks involved. For example, your financial advisor praised a certain fund stating that it has been generating over 15% returns for the last 10 years. You anchored this fact. However, he also mentioned that a standard deviation of 12 makes the fund very volatile in nature. This was the part your memory decided to forgo.

The opposite happens when you have decided against investment in Mutual Fund. No matter how much a fellow investor or advisor praise a certain scheme or fund. You have anchored the facts of Mutual Funds being risky, volatile, time consuming and all other facts that favours your decision to not invest in Mutual Funds.

One of the most common features that are often used to describe Mutual Funds is one of the most efficient returns generating instrument if investors stay invested for three to five years or preferably for longer term. Investors tend to anchor the information of efficient return generators. They invest in Mutual Funds with sky high expectations but feel disheartened when the anchored information of return generators does not reflect in their investments. Investors want quick returns but are not willing to invest time in that process.

Investors often enter Mutual Funds when the fund is at a high point and anchor the high point as the base return. In the short term there maybe variations in returns and it tends to fluctuate. Some investors also anchor the past performance as the reflection of the fund’s future performance. As a result a lot of investors invest at a high point of the market and exit at a low point of the market.

Anchoring is the reason why a lot of myths about Mutual Funds are perpetuated. Investors anchor the information that mutual funds are risky when to want to avoid investing in Mutual Funds. If a fellow investor mentions that Mutual Funds have been generating return of 20% we anchor that information and use that as a reference point while making investment decisions or talking to others. The bottom line is we anchor the information that is favourable to us at a given point of time.

Anchoring & Salience: The Stock Markets

Anchoring works in the same manner in the context of stock markets. When an investor enters the market at a high point, they anchor the point of entry. When the market starts to fall they are still waiting for the market to come back to the anchored point and rise even higher. In discussions with relatives and fellow investors, they use the high entry point of market as where the market should be giving people the illusion that markets are usually high.

Stock market investors use mental anchoring when they are not aware of what the right number should be. To dispel ignorance they anchor their knowledge to a number and use that as a reference point for their investments. Investors also tend to anchor their ideas based on the latest market movements. A lot of investors may be aware of the long term strategies and have their investments sorted out. However, they are emotionally swayed by short term market movements. They want to or are investing in sectors and stocks that have been recently doing well. If you do not believe this remember the last time when you were tempted to respond to the stock which had a stellar performance. They eliminate the sectors which have failed to live up to their anchored expectations in the short term.

How can Investors Avoid Anchoring

It is very hard to sieve noise from information. A lot of times investors or other sources of information state “The market is high” or a certain sector is performing well. They are just shedding light upon the short term movement. One of the ways of avoiding anchoring is to not get carried away by a fund or stock’s historical performance and make that the benchmark for its future performance.

If you are anchoring yourself to certain numbers, you are just scratching the surface of a very broad area. Anchoring is used to widely because we want quick solutions to complex problems without having to go through the trouble of acquiring knowledge. There is much more to a stock or fund than its performance and returns. As an investor make an attempt to get yourself acquainted to the subject of investing. When you anchor yourself to certain number or benchmark performances for future references, you are just finding a shortcut to dispel your investment ignorance in. In this process you reduce your chances of earning returns. Anchoring could also be a means of letting your emotions get the better of you and your rational investments.

Conclusion

If you do not loose of the anchor, the ship will never be able to sail to seek newer lands. It will be on the harbour full of unleashed possibilities and thirst for adventure. The ship could have taken you for a ride but it remained anchored forever. The same applies to your investment philosophy. You will never know the power of investments, returns and compounding unless you allow yourself to be free of the bondages that you have created for yourself.

The number and the benchmarks that you have created that do not allow you to venture into new investments. Your investments are full of possibilities but you have to allow yourself to broaden your horizons. Anchoring is like fumbling for a chair in a dark room; when you finally find the chair you hold on to it. However, if you decide to let go and keep fumbling for a little more you never know what all awaits you in that dark room.

We are humans at the end of the day and we make mistakes. Instead of being the sole decision maker of your investments, take some help. Take help from the experts called financial advisors, who will be able to give you an objective and unbiased view of your financial situation. This way you do not have to cling on to numbers and performances. Rather you can rely on concrete information and make some good investment decisions. Stop restricting yourself to the harbour and sail free for investing adventures await you.