Introduction:
Ever since the markets reopened after the COVID-induced lockdowns, the equity markets around the globe have attracted the attention of investors, and India is no different. The markets, too, have given them the reasons to do so with constant bull rallies. Several other factors, such as decreased interest rates, fluctuations in fixed-income products, increased knowledge of investment choices, and the convenience of mobile trading apps, have also helped investors.
However, amid this euphoria, investors often get entangled due to certain psychological biases and make wrong investment decisions. One such psychological bias that frequently impacts investment decisions is the anchoring effect. Recognising this phenomenon and knowing how to counteract it can be pivotal for successful and bias-free investing.
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In this blog post, you will delve into the details of the anchoring effect, including its meaning, significance, and how you can avoid its influence while making your stock investment decisions.
What is the anchoring effect in investing?
At its core, the anchoring effect is a cognitive bias where investors rely too heavily on the first piece of information they encounter (known as the "anchor") when making investment decisions. Once this anchor is set, subsequent decisions are often adjusted around this initial point, regardless of its relevance or accuracy.
In other words, anchoring refers to the inclination investors have to fixate on a specific reference point or piece of information, even if it doesn't logically relate to their current investment decision. Typically, this bias arises when investors focus on irrelevant details, resulting in mistakes in their investment choices.
For example, while choosing a stock for investment, investors often check its 52-week low and 52-week high prices. This initial information serves as the anchor in their minds. Now, they tend to make their investment decisions based on this bias. However, the 52-week high or low price can be misleading. Although the current stock price may seem lower or higher in comparison, the stock might still be undervalued or overvalued.
Impact of the anchoring effect while investing
As mentioned, the anchoring effect can create a psychological bias in your mind and lead to misleading investment decisions.
- You may buy a stock at the wrong price
As the above example explains, if you anchor on a stock’s 52-week high price, you might consider its current market price (CMP) as a bargain even if the fundamentals have deteriorated. As a result, you may end up buying the stock at its CMP, which could lead to potential losses in the future. Conversely, if your anchor is the 52-week low price, you might overlook the stock’s growth potential and miss out on potential gains.
- Reluctance to adjust your investment strategy
The anchoring effect often creates a cognitive bias in your mind while making your investment decisions. You might hold on to a particular investing strategy or method and might resist changing your strategy based on changing market conditions, potentially missing out on better opportunities.
- The amplification of losses
One of the most dangerous outcomes of the anchoring effect is that it can lead to the amplification of your losses. It might happen when you keep holding a declining stock in anticipation that it will return to the anchor price, even when it’s unrealistic. In the end, you might end up with significant losses.
Tips to avoid the anchoring effect in investing
Below are a few strategies to counteract the impact of the anchoring effect on your investment decisions:
- Rely on multiple sources for stock analysis. Doing so can help prevent fixation on a single piece of information or price point
- Establish clear criteria based on the issuing company’s fundamentals, growth prospects, and valuation metrics before making your investment decisions
- Regularly revisit and adjust your investment criteria based on the evolving market conditions
- Implement stop-loss orders to mitigate the risk of holding onto a declining stock based on an anchoring bias
- Review your investment portfolio frequently. Reassess your holdings without being overtly influenced by any anchor parameter in your mind
- Continuously educate yourself about behavioural finance and cognitive biases. Awareness is the first step in mitigating the influence of such biases on your investment decisions
To conclude
The anchoring effect is a potent cognitive bias that can significantly impact your stock investment decisions. You can make more informed and rational decisions by understanding its implications and implementing strategies to counteract its influence. With Motilal Oswal, you can open an online Demat account and seamlessly invest in stocks.
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