Anchoring Risk in Client Investing
Good to Know
This blog is the first in a series to identify common psychological influences that can lead clients to financial decision errors. We begin this series with a common influence referred to as Anchoring.
Anchoring Defined
Anchoring is regarded by some as one of the most powerful psychological influences in the human brain. The Anchoring Heuristic is named after a boat’s anchor and is used as a metaphor to describe a starting point in making a decision. Heuristics are simplification strategies when an exhaustive search for an optimal answer isn’t practical. By identifying an initial position (aka a “reference point”), the search can be quickly narrowed to a smaller range of potential outcomes or options.
Pros and Cons
Anchors can be very useful when making decisions and judging outcomes. For example, if we determine through a quick Google search that our used Toyota Corolla has an average trade-in value at the dealer of $8,000 and a range (based on condition, etc.) of $7,000 to $9,000, we can easily make an informed decision. If the dealer offered us only $6,500, we would likely be reluctant to complete a deal. In this case, the average trade-in value and the range of outcomes were very useful information and served as anchoring points in our decision.
However, in other situations, anchors can lead to poor judgments and decision errors. For example, if the initial anchor point is not characteristic of a typical outcome, using it as a benchmark to judge success or failure would not be appropriate. In other situations, there may be disagreement on the evaluation criteria. We refer to this risk as “moving the goalposts.” In most cases, this can be remedied by resetting the anchor with a more appropriate benchmark. But in some cases, both parties may not even be aware of the discrepancy and, in extreme cases, anchor on information that isn’t relevant to the decision at all.
Frequently seen anchoring behavior includes Market Return, Cost Basis, High Water Mark, and Volatile Positions.
Market Return
Many clients compare the gross return results of their portfolio against a benchmark like the S&P 500 without taking the asset allocation or risk-adjusted returns of their portfolio into consideration. Assuming a diversified portfolio invested 60/40 into equity and fixed income securities, this can lead to a perception of persistent underperformance in bull markets. This perception, left uncorrected, leads to client dissatisfaction with the level of market participation, which can ultimately impact the relationship or lead the client to chase return to the exclusion of investment risk management.
Cost Basis
A client’s cost basis is likely to serve as an anchor to judge future performance. Studies show that cost basis also has a significant influence on a client’s tendency to trim “winners” and hold “losers.” The potential decision error is to ignore the underlying basics of the stock and make buy, sell, and hold decisions based purely upon its cost basis.
High Water Mark
Similar to cost basis, a client’s highest account value (their high-water mark) may serve as an anchor that can influence behavior. For example, clients that suffered significant declines during a financial crisis may be more likely to “sell out” once the portfolio value gets “back into the black” and exceeds their previous high-water mark.
Volatile Positions
Clients also have a tendency to focus on individual components versus the portfolio as a whole, especially positions that have experienced significant declines. In some cases, these can be small positions that are inconsequential to the overall return of the portfolio but may become a focal point during a performance review.
Summary
The “rational investor” contemplated by Modern Portfolio Theory is a human being and, as such, is pushed by psychological influences to act “irrationally,” such as expecting S & P 500 performance from a portfolio with a significant allocation to fixed-income securities. The role of the financial planner or advisor is to make their clients aware of the risks of Anchoring and, by doing, coach them to reduce financial decision errors.
Disclaimer
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide Social Security, retirement, tax, legal, insurance, investment, compliance or financial advice. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.
