Anchoring Bias in Stock Valuation

Anchoring causes investors to fixate on irrelevant numbers when making decisions. Understanding this bias helps you value stocks more objectively. [DEFINITION] Anchoring Bias: The tendency to rely too heavily on the first piece of information encountered (the "anchor") when making decisions, even when that information is irrelevant. ### Common Anchors in Investing **Purchase price:** "I'll sell when it gets back to my buy price." (The stock doesn't care what you paid.) **52-week high:** "It was $100 before, so $60 must be cheap." (The previous high may have been overvalued.) **Round numbers:** "It will definitely hit $100." (Round numbers have no special significance.) **Analyst price targets:** Fixating on a specific target rather than a valuation range. [EXAMPLE] You bought at $50. The stock falls to $30. You anchor to $50 and hold, waiting for recovery. Meanwhile, the fundamentals deteriorate and the stock falls to $15. Your anchor prevented rational assessment at $30. [KEY] The only relevant question is: "What is this investment worth today, and what will it likely be worth in the future?" Your cost basis is not part of this equation. ### Why Anchoring Is Dangerous **It prevents selling losers:** You wait for an arbitrary price that may never return. **It prevents buying at good prices:** "It was $40 before; $35 must still be expensive." (But maybe $40 was undervalued and $35 is even better.) **It creates false precision:** Specific price targets suggest precision that doesn't exist. ### Breaking Free from Anchors **1. Evaluate from scratch:** Ask: "If I had cash instead of this position, would I buy it at today's price?" **2. Use valuation ranges:** Think in ranges (fair value $40-$60) rather than precise targets. **3. Focus on fundamentals:** Value based on earnings, cash flow, and growth—not historical prices. **4. Challenge your reference points:** Ask: "Why am I using this number as a reference? Is it relevant?" [TIP] Before checking your portfolio's performance, try to value each holding independently. Then compare to market price. This reduces anchoring to your cost basis. ### The Fresh Eyes Test Imagine you have no existing positions. With fresh eyes: - Which stocks would you buy today? - At what prices? - In what sizes? Compare this to your actual portfolio. Significant differences suggest anchoring. [EXERCISE] A stock you don't own was $100 last year and is now $50. Your friend says, "It's 50% off! Great deal!" Why might this reasoning be flawed? |ANSWER| The previous price of $100 is an anchor, not evidence of value. Key questions: 1) Was it overvalued at $100? 2) Have fundamentals deteriorated (justifying lower price)? 3) What is it actually worth based on earnings, cash flow, growth? A 50% decline could mean it's cheap, fairly valued, or still expensive—the anchor tells you nothing about intrinsic value. ### Case Study: The 52-Week High Anchor Stock XYZ hit $150 at its 52-week high. It now trades at $80. **Anchored thinking:** "It's 47% off its high! Must be a bargain!" **Objective thinking:** - Why did it hit $150? (Hype? Overvaluation? Legitimate growth?) - What changed? (Earnings miss? Competitive threat? Sector rotation?) - What is it worth today based on fundamentals? - Is $80 still expensive, fair, or cheap? [WARNING] Many "cheap" stocks that fell from highs continued falling. The 52-week high is often overvalued, not a target to return to. [SCENARIO] You bought a stock at $100 with a thesis that it was worth $150. It dropped to $70. The business is unchanged. How should you think about this? If your thesis is intact and the business hasn't deteriorated, the $70 price might represent an even better opportunity. But examine honestly: 1) Was your original $100 purchase based on sound analysis? 2) Has anything changed in the business? 3) Is the market seeing something you're missing? If truly unchanged, buying more at $70 could be smart. But don't let your $100 anchor prevent you from objectively reassessing.