Download Monthly Column Anchored on a drifting seabed Imagine you are

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%.