Behavioral finance:
How “anchoring” can confound investors
This document is intended for the general information of financial advisers only. Fidelity does not authorise distribution to retail investors.
This article is the first in a Fidelity series designed to help advisers better understand the emotional drivers that can lead investors to reckless investment decisions. The first installment is an introduction to behavioral finance and the concept known as anchoring — a human behavioral bias that frequently handcuffs investors.
What is behavioral finance?
One of the common assumptions in modern economic and financial market theories is that people behave rationally. However, some critics argue that people at times can be anything but rational when it comes to investing. Although most people view themselves as impartial, logical, and practical thinkers, emotions can impair sound judgment.
Behavioral finance is an academic field that studies how the unpredictable nature of human psychology influences investment decisions. At times, emotionally driven behaviors can cause market anomalies, such as distorted security valuations that, in the aggregate, may become either speculative bubbles or hopeless bear markets.
For advisers, behavioral finance provides an opportunity not only to recognise the habitual weaknesses to which humans are prone, but to learn how to help their clients overcome them.
Two US psychologists considered the pioneers of behavioral finance — Daniel Kahneman and Amos Tversky — proposed that human errors often stem from the various methods used to make a decision (formally called heuristics) — such as rules of thumb, educated guesses and intuitive judgments. They found that adopting such decision-making methods can lead to cognitive (thoughtful) biases (sometimes in collaborations with others). These biases can lead smart people to make rash, illogical decisions at times.1
The investor’s mirage – Anchoring
The concept of anchoring is a cognitive bias that refers to the tendency of people to attach or “anchor” their thoughts to one particular piece of information when making a decision, even if this information is an irrelevant or insufficient benchmark.
According to the findings of Kahneman and Tversky, in the absence of better or new information, people often place too much credence on simple, accessible reference points, then maintain a bias toward those reference points when making a decision.2 For instance, home owners may base the value of their homes on the sale price their neighbors living across the street accepted rather than a wider study of the real-estate market.
Anchoring – The US tech bubble
People often base their investment decisions on pointless anchors as well. In the US, the classic reference period for poor investor behavior was back in 1999-2000, when euphoria over Internet stocks and a potential “new economy” steered many people off course from carefully constructed investment plans.
The tech-heavy NASDAQ Composite Index peaked at 5048 on 10 March 2000. By May 26 that year, this benchmark had plummeted 37% to 3205, which was no doubt seen as a buying opportunity by some investors who were using the nominal 5000 price point as an anchor, or price target they felt would be revisited.
Only a few trading days later, on June 2, the NASDAQ had risen nearly 20% to 3813, likely reflecting higher levels of buying interest among the investment community. However, it proved only to be a temporary rally in a prolonged bear market. Some seven years since its all-time high, the NASDAQ is still more than 50% below its peak.3
For several months after the NASDAQ peaked in 2000, it’s realistic to assume the key mistake many people made was staying “anchored” to an artificial benchmark, which is this case was unusually high tech stock prices.
An alternative anchor would have been to base return expectations on the long-term history of technology stock performance — the NASDAQ returned roughly 10% annually from 1971 to 1996. Then it soared 22%, 40% and 86% in 1997, 1998 and 1999, respectively.
So in May 2000, even though the NASDAQ had corrected more than 30% from its all-time high, it was still more than 70% above what would have been expected had it continued to earn its long-term historical average return of 10% (see Exhibit 1).
Investors who overexposed their portfolios to tech stocks may have fared better had they remained anchored to a long-term investment plan that included a diversified mix of assets consistent with their goals, risk tolerances, and time horizons.
EXHIBIT 1: Post-tech-bubble investors who anchored to the NASDAQ's 2000 peak have been disappointed
Source: FactSet, Fidelity
Finding a reliable anchor
More recently in the US, the S&P 500 index made headlines in 2007 after setting a new all-time high in May, eclipsing its previous high point touched in March 2000 (1527) before setting even higher marks in June, July and October.
However, in 2007, many investors were apprehensive about owning US stocks. Investors pulled a net US$14 billion out of US equity managed funds during the six-month-period ending October 2007, compared to an average six-month net inflow of $47 billion from 1997-2007.4
What caused the lack of interest in stock funds in the US? It’s hard to know for sure, as many factors — including the economy, interest rates, corporate profits, geopolitics, etc. — can influence the stock market at any given time. But anchoring may have played a role.
With the scars from losses incurred during the three-year bear market that followed the tech bubble still fresh in investors’ minds, the net outflow from US managed share funds may have represented a concern that new market index highs signaled a peak similar to 2000. But is a new record-high in and of itself enough of a reason to form the basis of an important investment decision?
Not particularly. Despite the S&P 500's new nominal high, the index’s aggregate price-to-earnings (P/E) multiple has been about on par with its historical average of 17 throughout the year — and a far cry from the P/E of about 30 in March 2000 (See Exhibit 2).
Thus, on this valuation metric alone, it would be hard to argue that the S&P 500’s new record was a warning signal of too much froth or irrational exuberance in the market, as was the case in 2000.
Anchoring to a more meaningful metric — in this case, a market’s overall P/E — might have led to a different behavior: maintaining one’s targeted allocation to the asset class. As always, a thorough analysis of multiple pieces of information is always the best approach when considering an investment.
EXHIBIT 2: When the S&P 500 hit new highs in 2007, its price-to-earnings valuation was far more reasonable than during March 2000 – when the index previously peaked
Source: FactSet, Fidelity
1 While Daniel Kahneman and Amos Tversky were early pioneers in developing psychological theories based on cognitive biases and heuristics, it was economist Richard Thaler who integrated the research of those psychologists with economics and, according to Kahneman, made “important discoveries in what is now called behavioral finance.”
2 Anchoring concept based on findings presented in “Judgment Under Uncertainty: Heuristics and Biases” article, authored by Kahneman and Tversky that first appeared in Science, 1974.
3 As of 7 December, 2007 the NASDAQ Composite Index stood 46% below its record high reached on 10 March 2000.
4 US equity managed funds include all US-based managed funds in the following Morningstar categories: large value, large core, large growth, mid value, mid core, mid growth, small value, small core, small growth. Source: Simfund, Fidelity
