Thursday, July 16, 2009

anchoring bias

In a famous paper from 1974, behavioral scientists Tversky and Kahneman describe this bias in the following manner:
In many situations, people make estimates by starting from an initial value that is adjusted to yield the final answer. The initial value, or starting point, may be suggested by the formulation of the problem, or it may be the result of a partial computation. In either case, adjustments are typically insufficient That is, different starting points yield different estimates, which are biased toward the initial values. We call this phenomenon anchoring.
Tversky and Kahneman observed this behavior in a number of experiments conducted in the early 1970s. In the most well-known of these studies, the researchers asked participants to estimate the percentage of African countries in the United Nations. The results indicated that people anchored their answer to completely arbitrary numbers presented by the researchers. For example, the median estimate of people who were given 10% as a starting point was 25% and the median estimate of people who were given 45% as a starting point was 65%. Specifically, people became anchored to the percentage suggested to them by the question even though that number had nothing to do with the actual percentage of African countries in the UN. Having no knowledge of the exact percentage, people subconsciously took their cues from the numbers presented in the questioning despite the fact that those numbers were randomly generated.

Now, how does this bias manifest itself in the investing world? I think the main way in which investors can fall prey to this pitfall is by paying too much attention to the past prices of securities. The two most prevalentnumbers that people seem to anchor to are the 52 week high and 52 week low for a stock. Setting aside technical analysis, in my young career I have observed a marked tendency for people to assume that a stock has potential to get back to its 52 week high but not breach its 52 week low. I think this is a reflection of the eternal optimism that exists in the market. On some level even short sellers believe that the market’s trajectory over the long run is more likely to be up than down. The problem with this thought process is that it assumes that those numbers are an indication of value and are not just random outcomes based on the whims of the market. In the end the value of a stock should be based on its earnings potential, a value that at certain times may have absolutely nothing to do with the current stock price. A quick look at the ride the Nikkei Stock Exchange has had over the past 20 years provides a sobering reminder that previous highs may never be reached again and stocks can stay at low nominal values for a protracted period.

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I dunno. Since anchoring exists, technical analysis must work too. In the sense that people do look at previous levels which must act as some form of resistance and support, regardless of the fundamentals.

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