Humans operating on any level of the IQ spectrum are bound by the same limits on perception created by our cognition. These biases steer the behavior of mankind toward patterns that can be used to the advantage of traders active in the stock market. Dozens of these tendencies have been measured by scientists, but today let’s discuss one bias in particular that keeps us grounded tightly in what we know: the anchor bias.
Download a PDF version of this post as PDF.
The metaphorical anchor refers to the first piece of information that you receive about a topic or entity. The concept, also known as focalism, alleges that humans tend to support the veracity of the anchor more heavily than other pieces of information they acquire about the same subject down the road.
Simple thought experiments can reveal this bias pretty clearly.
One interviewer asks you: “Is the population of Madagascar over 10 million?”
The next one asks you: “What’s your best guess of Madagascar’s population?”
Even though you do not have enough time to research what the actual population of the island country is between rounds, your second guess will likely be close to the 10 million mark. It becomes the number you cling to, even though you have no real data to prove its accuracy.
The same anchoring effect takes place when families plot their strategy to secure a great deal on a new home. The elders agree on a deal that is $93,000 less than the asking price, but did that drop come from “The Art of the Deal”-level negotiating skills, or is it just another example of focalism at its best?
Big retailers face this bias when setting chain-wide sale policies. A few years ago, the mass market department store J.C. Penney decided to withdraw its wildly popular coupon policy, opting for an “everyday low pricing” scheme. Customers abandoned the company in droves because without working for the discount – i.e., finding the coupon, saving it, and using it at the register – they felt that the company had conned them out of the rewards: cheap jeans and sunglasses.
This bias even affects our parameters for a life well-lived.
StocksToTrade—now better than ever! We ushered in the New Year with some major advancements that include 3 unique features, exclusive to our Platform.
Suppose Matt’s dad died of a chronic disease at the tender age of 51. For Matt, dying at 80 would seem like a real treat. But Samantha’s parents both died well into their 100s, still walking, talking and bickering. To her, dying in her 80s would seem like a raw deal. This is because her anchor set her expectations high in the sky, even though her parents’ lifespan probably has little to do with how long she will live. Sam’s tendency to eat out, live a sedentary lifestyle, and related factors will play a much larger role in limiting her maximum age than genetics will in raising it.
Stock traders are vulnerable to the same flawed thinking when faced with new opportunities.
Think about the last time you read an article about a “hot” stock and felt a tinge of excitement – exactly the feeling the writer meant to invoke in you. That spark is hard to forget and will color your understanding of the company as you consider making an investment. Unbeknownst to you, the anchor bias will likely cause your research to remain incomplete because of the ambiguous “gut feeling” of positivity that has already entered your consciousness.
“Go, go, go,” your mind will say, which is when your confirmation bias will kick-in. You’ll find yourself clicking on articles that give a glowing face to a stock you’ve been primed to think of positively.
“You only get one chance to make a first impression,” according to every interview readiness article ever – and this bias is why.
As with your experience as a nervous interviewee, when that the first impression you made wasn’t really the most accurate one. It’s all a façade–a direct function of the number of practice questions you answered in front of the mirror and the amount of sleep you got the night before. Does your behavior during that short meeting really represent your real personality or professional abilities? Probably not.
A quick way to prevent this bias from playing a role in your trading practices is developing a template that identifies the key stats you need to evaluate a buy or sell opportunity.
Make a quick excel sheet and list it all out: stock price, free cash flow, last quarter profits etc. Only invest when you have filled out 100 percent of the template every time, so you know you’re giving every company as fair and equal a chance as possible, unguided by any media hype that you’ve consumed.
This will prevent you from keeping your money in a company that has already caused your portfolio a big loss and looks determined to follow the downward streak. And it will save you from making an investment based on random hints from blips in the market or celebrity stock picks, rather than a unified strategy.
Stay vigilant and keep your eyes, along with your Excel workbook, open.
You demanded it, and we delivered: StocksToTrade now offers Paper Trading and a new Trading Module. Our Paper Trading platform offers our customers a safe environment to practice trading without ever having to risk a cent of their capital to the market. By leveraging the real-time data provided with our service, the paper trading simulation offers an experience as close to real trading as possible. Learn more …