Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Syndicated loan wikipedia , lookup
Investment management wikipedia , lookup
Financialization wikipedia , lookup
United States housing bubble wikipedia , lookup
1973 oil crisis wikipedia , lookup
Stock trader wikipedia , lookup
Land banking wikipedia , lookup
Investment fund wikipedia , lookup
Monthly Column Anchored on a drifting seabed Imagine you are bartering in a market for a hand-woven rug, when the stall-holder starts negotiations with a ridiculously high price. You know the price is too high and you must adjust downwards but your brain still has to make a sensible adjustment from that crazy starting price, regardless of how fanciful it is. Of course, the stall-holder is hoping that you do not make a sufficient correction from this initial number, so that you still end up paying more than the item is worth. It’s an everyday example of one of our most common decision-making frailties: our tendency to anchor to numbers (often irrelevant numbers) in the face of uncertainty. In the investing world, numbers - and potential anchor points - are ubiquitous. Share prices, economic growth rates, stock market levels provide ample opportunity for anchoring: this is why it is one of the most common cognitive traps into which investors regularly fall. Financial forecasting, in particular, provides an extensive canvas for the anchoring bias to run free. Despite evidence that suggests humans are quite bad at predicting the future, the abundance of financial forecasts published everyday demonstrates that getting it wrong rarely stops us from trying. Imagine two reports which make forecasts for gold prices a year from now. Gold is a volatile commodity with a large amount of speculative interest and is subject to an array of potential price drivers. Report A suggests a doubling of the price based on current trends. Report B suggests a tripling. Investors who read report B might be disinclined to sell after a mere doubling of their investment – they are anchored to the idea of a tripling. Investors who read both reports might anchor to a point in the middle of the two forecasts. Yet, this may be no more sensible. What if the world moves on and the gold price actually falls? Investors risk hanging onto a losing investment by clinging to these psychological price anchors. Forecasts of share prices, economic growth, consumer demand or commodity supply are invariably anchored to the current state of affairs, combined with an analysis of prevailing trends. While these may be an intuitive, well-intentioned and often well-informed attempt to predict future trends they are inevitably based on assumptions. The forecaster forever runs the risk of being made to look stupid by any number of unexpected real world developments. Much of the negative impact of anchoring is exacerbated by other behavioural biases such as hindsight, overconfidence, and a pernicious, attachment to “narrative fallacy”. The latter is a recurrent, unifying theme in behavioural finance – in this case, the forecaster has essentially bought into a story that seems to justify the forecasts. The problem is the story may or may not develop as anticipated – and the story itself is typically a hugely simplifying device. Everywhere, narratives are superimposed on to our understanding of the world, past, present and future. They are cognitive shortcuts to understanding a world that is more chaotic than we like to imagine. Author, Nassim Nicholas Taleb was effective in popularising this concept in his books, ‘Fooled by Randomness’ and ‘The Black Swan’. For instance, the narrative of ‘peak oil’ (the idea we face a looming energy crisis as surging energy demand outstrips dwindling oil supplies) became a popular one in investing circles only five years ago when oil prices were rising strongly. It quickly gave rise to some extreme forecasts for oil prices. Since then, discoveries of deep-water and shale-based oil and gas supplies have substantively transformed the energy supply picture. So much so, that a recent report by Citigroup announced the ‘peak oil’ hypothesis to be “dead”. Bear in mind, that only a few years ago, some forecasters were belligerently staking their reputations on it! Taleb is right, of course. The real world is more chaotic than we give it credit for. Forecasts extrapolated from past trends are regularly made to look naïve. By attempting to anchor our decision-making in challenging seas, we must remember that the sea bed itself is capable of drifting, forcing us to regularly re-examine complex and evolving situations. Anchoring in forecasting is a conscious, ‘best guess’ exercise and investment professionals are acutely aware of the pitfalls. More dangerous is the subconscious anchoring to irrelevant numbers that derails many investors. Why does the share price level an investment is bought at act as an anchor on future decisions, even when the investment picture has changed substantially? Most worrying is the fact that anchoring happens when people know they are being presented with irrelevant information. The classic example comes from behavioural finance godfathers, Kahneman & Tversky’s wheel of fortune experiment.1 They asked undergraduates general knowledge questions, such as ‘what percentage of the United Nations is made up of African countries?’ A wheel of fortune was spun in front of participants before they answered; however it was rigged to either give a result of 10 or 65. The median response from the group who saw the wheel stop at 10 was 25; the median response from the group who saw it stop at 65 was 45.2 Proof positive that our brains seem to be against us, anchoring not just to numbers with questionable relevance (like share prices), but clutching at numbers that are indisputably irrelevant. In investment, the tendency to anchor is all around. Many investors are guilty of latching onto market prices as an indicator of value. This is fraught with danger, as prices may subsequently prove to be overvalued or undervalued. They are simply the market’s current estimation of value, which may or may not reflect the real or intrinsic value of a company. So how should investors deal with anchoring when the evidence suggests the tendency to anchor is overwhelming? James Montier, one of the leading authors in the arc of behavioural investing, has an interesting and practical suggestion. It is that investors should embrace anchoring (as they will do it anyway) but anchor to something sensible with real predictive power, namely dividends. While earnings can be manipulated by a variety of sophisticated accounting treatments, dividends cannot. In this way, they provide an accurate barometer of a company’s financial health. Academic studies suggest that bubbles are more likely to appear in stocks when investors lack dividends as an anchor. Dividends and dividend yields provide a way for investors to understand price relative to value. Equity income investing has always been seen as appealing to the patient investor; now it also has behavioural appeal to those who want to overcome common investing vulnerabilities. SSO5072/0213. 1 Tversky, A. and Kahneman, D. 1974. Judgment under uncertainty: Heuristics and biases. Science, 185:1124—1131. 2 The actual answer is around 20%.