In Investing, Catch the Right Anchor to Avoid Sinking

First, a quick question. Take the last three digits of your telephone number, and add 400 to it.

So if your telephone number ends in 146, adding 400 to it will give you the answer 546.

Now answer this question – In which year did Alexander invade India?

Think…think!

Even though your telephone number has nothing to do with ancient India’s battles, you will note that your answer to the above question would most likely revolve around the first number i.e., 546 in the above example.

Whatever number you come up with for the sum of the last three digits of your telephone number and 400, your guess for the year of Alexander’s invasion will be close to your sum.

Since you might have a biased answer to this question now having read it, you can try this exercise on anyone else. You’ll be amazed at the results. By the way, the answer to the above question is 326 BC.

Psychologists call this process as ‘anchoring and adjustment’, or simply ‘anchoring’.

What this means is that as soon as our intuition gets fixated with a number – and that can be any number – it sticks with us.

Most of our decision-making errors result from mental shortcuts that are a normal part of the way we think. The brain uses mental shortcuts to simplify the very complex tasks of information processing and decision-making.

Anchoring is the psychologist’s term for one shortcut the brain uses. The brain approaches complex problems by selecting an initial reference point (the anchor) and making small changes as additional information is received and processed.

‘Anchoring’ bias is mostly used by salesmen and marketing experts to sell us their stuff.

By showing us their most expensive product and then a less expensive one, they make us buy the latter by making us see the second product as inexpensive.

Smart real estate brokers, for instance, will usually show you the most expensive house in the locality first, so that other houses that he shows later will seem cheap in comparison.

We all know of the US based tech company Apple, the maker of iPhones and iPads. Apple has used the anchoring bias to create huge revenues for itself over the past many years.

Take for instance the launch of its iPhone in 2007. When the company launched this phone, it set its price at US$ 599 with a view to skim high profit from early adopters, who would have paid anything to get their hands to the latest technology marvel.

After the initial launch and after clocking in huge sales, Apple cut the iPhone prices by one-third, to US$ 399.

Was this a mistake on Apple’s part to lower the prices of this hot-selling product? Not really! In fact, it was a very smart move. Consumers, who had thought the original price of US$ 599 was expensive, jumped to this lower price.

The higher price was a good enough anchor for them to consider this reduced price (which was still high) as inexpensive!

Marketers call this the ‘price anchoring’ strategy. Consumers, despite being fooled by it many times over, still don’t get it.

Similar price anchoring tactics are used everywhere, and with much success.

Restaurants, for instance, price some of the items in their menus at expensive levels to make their mid-priced meals look like a good value to eaters.

Anchoring and investing
Anchoring influences all kinds of purchases. And investing in stocks is no different.

In fact, anchoring is everywhere in the financial world.

You can’t be fully on guard against it until you understand why it works so powerfully.

One prominent example of anchoring in the field of investments is when a mutual fund stresses on its Rs 10 net asset value or NAV as ‘cheap’ while launching a new fund scheme.

In effect, net asset value is nothing but the total money under management in a mutual fund scheme divided by the total number of outstanding units of that scheme. So if a fund has Rs 1,500 under management, it will divide it into so many units that the NAV per unit comes to Rs 10.

Here, the number of units will be 150 (1,500 divided by 10). All mutual funds coming out with new fund offers or NFOs for new schemes price their issues at Rs 10 per unit of NAV.

They manipulatively stress so much on this number (Rs 10), that investors start to believe it as a ‘cheap’ number, which is not really the truth.

The same holds true when investors think that a stock priced at Rs 25 is cheaper than a stock priced at Rs 500.

In reality, the first stock might have 10,000 stocks outstanding in the market that will bring its total market capitalization to Rs 250,000.

On the other hand, the number of outstanding shares of the second stock might be much lower at 100, which will bring its market cap to Rs 50,000, or just 20% of the first stock.

If the two stocks belong to businesses of same size and quality, the first stock is indeed five times expensive than the second stock based on everything – earnings, assets, cash.

Similarly, a stock does not get necessarily cheap when it hits its 52-week low (although it may be a good place to look for value).

After all, a stock that is down 95% first fell 90% and then another 50% from there!

Then, it might be a bad decision to sell a stock just because it hit its all-time-high. All 10 or 20 baggers (stocks that multiply 10 or 20 times in price) must have touched their all-time-highs much earlier before becoming 10 or 20 baggers.

You need to compare the stock price to the company’s intrinsic value, and only then judge whether it is cheap or expensive. In effect, you need to anchor to the intrinsic value and not the stock price.

Assume a company that has lost its biggest customer – one who contributed to 50% of its annual sales. The stock price falls 30-40% in reaction to the news. Now, this fallen price in isolation (and as an anchor) does little to suggest the cheapness or expensiveness of this stock.

You need to understand that there has been a decline in the fundamental value of the company, and make the new intrinsic value as the anchor to judge whether the stock has really fallen to cheap levels.

As these examples suggest, you do need anchors in life (like a stock’s intrinsic value), but get the right ones to avoid sinking.