When an individual’s portfolio has reached a certain numerical value (i.e. $1 million, $2.5 million, $5 million, etc.), he tends to lock-in that valuation in his mind and is unwilling for it to move lower – at times even desiring to move to cash in order to preserve the valuation. If the market or his stock declines below the level in which he has locked-in the valuation, this can lead to irrational behavior driving the investor to sell his stocks at a lower valuation while also losing the dividend income from his investment.
When you rely on an initial piece of information to make subsequent judgments, you’re succumbing to anchoring bias. Psychologists use the term to describe the human tendency to rely too heavily, or anchor, on a single piece of information when making decisions.
This anchoring bias impacts many financial decisions. The awards from lawsuits are influenced by the plaintiff's initial demand — the plaintiff gets more by requesting more. In real estate, people are unconsciously influenced by arbitrary posted prices. In online auctions, the prices bid are anchored by the non-binding "buy-now price." Earnings forecasts by financial analysts are biased towards the previous months' data as an anchor.[i]
In addition to being harmful when causing an investor to panic-sell when their portfolio declines in value below an arbitrary number, an anchoring bias can also harm you when holding a few concentrated stocks.Let’s assume an investor has a million dollars in assets tied up in just one or two stocks and the value plummets by 30 or 40%. What I often see people do is tenaciously cling to those stocks, waiting for their values to return to their original worth. They refuse to sell, regardless of how long it takes. They are anchored to the higher value of those stocks. Similarly, when real estate prices drop, homeowners will refuse to sell their depressed properties until values return to previous highs or what they originally paid. This happens even when the homeowner is not underwater on the property.
I sometimes use an analogy to help clients abandon their anchoring bias. I ask if they were sitting on the cash equivalent of the diminished value of a declined stock, would they take that cash and reinvest it into that security? If the answer is no, which it almost always is, I ask, “Then why are you sitting on this investment? Learn your lesson, cut your losses, understand that it was a mistake, and properly diversify your portfolio going forward. Don’t make that mistake again.”
As a financial advisor, if I suggested to someone with a million dollars to invest it all into a single stock, they would probably look at me like I was crazy. They might comment, “Jim, you’re a nice guy with a good track record and you seem to have built up a good business, but that’s the dumbest thing I’ve ever heard.” However, that’s exactly what investors do when they have a large percentage of their portfolio invested in a single stock and refuse to sell any of it.Whether it is an individual stock, or one’s entire portfolio, it is important to fight your bias to anchor at a particular valuation and make short-sighted decisions. Instead, keep your head, think long term, focus on your current income (which likely hasn’t changed as the portfolio has declined) and make informed decisions for your future. A diversified and balanced portfolio constructed with a disciplined process is in my opinion a more prudent approach to accomplish your long-term goals than attempting to time the market or utilizing a haphazard trading strategy in which you can be quickly whipsawed by the market. Rather than worry incessantly about market gyrations or your portfolio which is lower by 3% from $1 million to $970,000, focus instead on the fact that your $45,000 - $50,000 in dividend and interest income hasn’t changed or altered your retirement plan. Fight your natural proclivity to anchor on a particular portfolio valuation and you will be a better investor. Doing so may at the least help you sleep better at night.
[i] John Nofsinger, “Surprised Again? The Anchoring Bias of Investors,” Psychology Today 21 Jul 2008.