Mental Models: Anchoring Bias

The investing community is well-known with all kinds of mental models which influence our decision-making and therefor our investing successes and failures. Charlie Munger eloquently introduced the concept of mental models and cognitive biases to investors in the 1990’s. During my years of investing I’ve read quite a lot about cognitive biases. I think we all did. Speaking for myself, I read and understand the impact, occurence and consequences of cognitive biases. But I‘m still an amateur in recognizing them in real-life and taking actions to prevent myself from making irrational decisions. One of my all-time pitfalls is anchoring bias.

What Is Anchoring Bias?

Anchoring is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions. Once an anchor is set, subsequent judgments are made by adjusting away from that anchor, and there is a bias toward interpreting other information relative to the anchor.

Checking 52-week Lows And Highs

Just like most investors I selected different companies as “must haves” for my dividend stocks portfolio. My selection criteria are fundamentals like valuation multiples, dividend yields, payout ratios and growth rates of revenues, earnings and dividend. It’s a list of 25 to 30 businesses qualified from dividend contenders to dividend kings. The majority of these companies currently trade at a P/E of or higher than 20. I’m talking about Accenture (ACN), Automatic Data Processing (ADP), Home Depot (HD), McDonalds (MCD) and Microsoft (MSFT) for example. All high-quality businesses trading at high valuation multiples.

Several days a week I check the trading prices of the companies I selected. During my weekly run-through of companies and their market prices I automatically compare their current price with their 52-week lows and 52-week highs. This has become my proxy for determining if a selected company is an interesting pick or not. I know this is anchoring bias at work, because the 52-week low is implicitly my reference point for qualifying a business as cheap and the 52-week high as expensive. But that reference point is actually, in several ways, quite meaningless. Let me explain along three lines.

Price itself is no actionable information. As Buffett said: “Price is what you pay. Value is what you get.” The gap between these two is valuable information. Scrolling the list of companies and their trading prices is maybe fun to do on a Saturday night while hot girls are twerking in your local club, but the price alone is not a good determinant for whatever decision; price holds no value. 

Valuation is a spectrum. A company is undervalued or reasonably valued within a certain price range. Let’s put it simple: a stock is undervalued between $10-13 and reasonably valued at $14-15 if you think the fair value is $15. Of course multiple principles and metrics do apply such as which margin of safety you’d like to have, the debt ratios, dividend yield and free cash flow to name a few. Pinpointing on a random trading price such as a 52-week low leads to a false sense of accuracy. The stock in the simplified example above is a good buy at $10, but also at a price of $11. The use of a bandwith of prices, always relative to fair value, is a better indicator to buy a stock or not. In other words, the stock is a buy within a buy zone, a certain price range. As Keynes strikingly stated: “It’s better to be roughly right than precisely wrong”.

The stock price in relation to its 52-week low or high does say something about the current mood of Mr. Market. Waiting for the price to drop to the level of Mr. Market’s most depressive day during the last 52 weeks means you think you’re able to time the market. Like I wrote about the mental models and cognitive biases above: I read and know timing the market is impossible to do, but my actions in real-life prove it’s difficult for me to act in that way. So again, the reference point of the 52-week low is meaningless. That specific price wasn’t knowable or rational in advance. “Mr. Market is there to serve you, not to guide you” is a famous quote by Warren Buffett.

A Real-Life Example: Fasten Your Seatbelts

At the end of 2015 I had my eyes on Boeing (BA), because of their attractive dividend yield, large order book and low valuation multiple. Prospects were rosy for this company. The stock price went sideways for a couple of months within the price range of $130-140. During a short period of time in 2016 it even traded for as low as $115, a P/E of 15 and a dividend yield of 3.70% in other words, undoubtedly cheap. See the graph below.

6A6145D6-BC31-4079-A106-7529FFD10FE2

But I decided to sit on my hands, and wait till it hit $100. Why? “The beauty is, with $1,000 I can exactly buy 10 shares. Nice round numbers, 10 pieces of $100 each makes $1,000.” Sounds like a strategy right? 🙁 But the thing is, the price never dropped that low. In 2,5 years it went straight to $420, with one big price decline, as you can see in the graph, hitting $300. Opportunity missed at $115 you may think. Well, that’s for sure. But I also missed it at $125, $150, $200, $250 and even at $300. Let’s keep it simple:

I MISSED THIS OPPORTUNITY FOR THREE YEARS. 😩

I remember that run-up in price like yesterday. My thoughts were the price would certainly come down to $115 again. When it hit $150 in no time I had missed a $35 profit or 23% a share. “I can’t buy this stock right now, no way. That would be insane.” I promised myself to immediately buy shares, when the price dips back to 130. Then it went up all the way to $200. Hey, that’s a 75% profit in comparison with my psychological anchor of $115. “It wouldn’t be rational to buy it at this price. Let’s wait for the next price correction and it trades at $175. At that price, I’ll be all over it.” The stock price easily rose to $300 within six months. But the shareholder returns didn’t stop there. Management of Boeing (BA) declared one dividend raise after another. In February 2016 the quarterly dividend was $1.09. In the same month, but only two years later the quarterly dividend was raised to $1.72!

You can see how wanting an extra $15 dollar discount on every share ($115 – $100) has eventually cost me an unrealized profit of more or less $285 (400 – 115) and missing a yield on cost of more than 7% (4 * 2.055)/115. Not good…

Conclusions

If you’re going down the wrong path, it’s likely that the next decision to turn left or right isn’t a good decision either. What I mean by that is: a dominant focus on market prices with investing leads in many cases to more irrational behaviour. Holding on to low trading prices in the past isn’t a good buy strategy as no one is capable of timing the market. To wait for a further price decrease, is a risky thing to do if the business is significantly undervalued already. I’ve missed many investing opportunities by wanting another 10% discount to fair value or wanting a buy price closer to the 52-week low. Boeing (BA) is just one of them. I can think of Lockheed Martin (LMT), Nike (NKE), Parkin Haniffin (PF) and T. Rowe Price (TROW).

Although I have done my homework on many stocks and looked into their fundamentals as good as I can, I’m still too much price-oriented. Do you recognize this? What do you do to minimize your anchoring bias?

Happy investing!

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