Avoid focusing on irrelevant information to prevent dumb investing mistakes
Mitchell Barr, Client Associate
One of my favorite television shows is American Pickers. Two roughneck guys named Mike and Frank roam the backroads of America and buy rusty antiques from people who have been stacking junk in their garages and basements for thirty years (must be my Midwestern roots). Then they bring the junk back to their store and flip it for a profit. It’s basically sixty minutes of pure nostalgia. I love watching it because I’m entranced by the haggling. There’re no price tags in picking. Every purchase is a gloves-off, bareknuckle boxing negotiation, and the pickers are very good at it. One tactic they use is to always throw out the first number. They start at 40 dollars, the seller counters with 50 dollars, and they usually meet in the middle at 45. Sometimes the pickers go first because the seller doesn’t know the value of the item — but there’s another reason why it’s important: That first price creates an anchor for the rest of the negotiation. Typically, the first price is about half of what the pickers think they can sell it for, and it all but ensures that they will get the item at a price that they can make a profit on.
First Impressions Matter
The anchoring heuristic is very powerful in investing as well, and you may not even be aware that it’s affecting you. Go back in time and remember the first investment you ever made. How did it do that first year? What was going on in the market at that time? Consider an investment in an S&P 500 stock index fund at the beginning of 2003. That year the S&P 500 returned a little over 28 percent, which is well above the historical average of 11.4 percent; more than double1. Studies on anchoring imply that two things are probably going to happen. Even if you are aware that 28 percent is an exceptionally great year for the stock market, you will still unconsciously anchor to that number when estimating what an average return should be in the future (I can see you shaking your head, but sorry it’s science). In addition, any adjustment you make in your brain from the 28 percent to curb your expectations will be decidedly less than the 16.6 percent you would need to subtract to reach the historical average return of 11.4 percent2.
Anchors in Action
So, how do you think this would have made you feel in 2005 when the S&P 500 return was 4.8 percent? Or in 2008 when the market was down over 36 percent? That anchor seems a long ways away. Many people who fall victim to anchoring start to chase performance when their investments do not meet their misguided expectations. Some people will even use the anchor from a previous investment for a new investment that is completely different. This happens a lot when people try to compare a diversified portfolio to the U.S. stock market. They are not even close to the same animal. The U.S. stock market is only a portion of a diversified portfolio that might contain a mix of global stocks, bonds, and real estate. Yet, watching that number for the S&P 500 every day can create an anchor that influences people to expect double digit returns every year for a portfolio that’s designed to return much less than that.
Goals Matter Most
All investments have up and down years. An alternative to anchoring to a specific return on your investments is to anchor to your goals. What are you investing this money for in the first place? If you are in your prime working years and the answer is retirement, there’s no need to freak out when your portfolio is down 10 percent in a year. The number is irrelevant if you are still on track to ride off into the sunset at 65. There’s no haggling with the stock market. Trying to negotiate for better performance will only cause you to buy high and sell low, which is a great recipe for going broke. Keep your eyes on the horizon and don’t let an anchor drag you down.
- http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
- Epley, N., & Gilovich, T. (2006). The anchoring-and-adjustment heuristic: Why the adjustments are insufficient. Psychological science, 17(4), 311-318.
Client Associate
Mitch writes the popular blog, The Money Monkey, where he focuses on common mental mistakes made by investors, how to avoid being your own worst financial enemy, and thinking about investing in new ways.
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