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Friday, July 3, 2015

How price ‘anchoring’ can hurt stock market returns

Price ‘anchoring’ is a cognitive bias. That means, your mind tends to play tricks with you at certain price points. You tend to take decisions based on perceptions or gut feelings that are often illogical.

Next time you visit a shoe shop, take a close look at the price tags on different shoe models. You will come across price tags of Rs 399 or Rs 999 or Rs 1499 or Rs 2999. Is the shop owner trying to fool you?

The answer is: Yes. Apparently, the number 99 has a strange effect on the mind. You know it is less than a 100, and that is some how very effective in closing a sale!

How does this bias work in the stock market? Here are three examples.

1) You have received a ‘tip’ about a bargain stock from a friend and decide to enter it at a price of Rs 32. It had touched a high of Rs 50 a couple of weeks back, but had corrected since then. Your friend says it can’t go any lower.

As often happens, the stock continues its correction after you buy. You wait for a month or two, but the stock fails to cross above Rs 25. You decide to hold on to get back your ‘buy price’. The stock moves up to Rs 28 – but you refuse to sell.

You get ‘anchored’ to your ‘buy price’. Only you know about this price. The market doesn’t, nor does it care. The stock falls below Rs 10 and stays there for the next 3 years. You finally sell it at Rs 6.

2) You do a decent amount of research and prepare a short list of stocks you wish to buy. You start tracking the stocks regularly. You are particularly keen on a stock that moved from Rs 50 to Rs 100, but is hovering around the Rs 85 level.

Finally, the stock dips to Rs 75 and you jump in to buy a decent quantity. You decide to be smart, and sell half your holdings when the stock hits Rs 150. The balance of your holding would then become ‘free of cost’.

Clever strategy – except that the stock refuses to move past Rs 135. You keep holding, but the stock drops to Rs 120. So, you hold some more – and it rises to Rs 135 again. But your mind is ‘anchored’ to Rs 150, and you don’t sell.

After a while (and by this time 2 years may have gone by), the stock drops to Rs 100. You sell off – happy to make a 33% profit on your ‘buy price’. But you lost out on a chance to make 80% profit by not selling at Rs 135.

3) You decide to enter the NBFC segment and short-list a stock trading at Rs 70. The company is a subsidiary of a well-known engineering giant. You decide to get a confirmation from an analyst friend before entering.

The friend suggests a different stock belonging to a less known business house that is trading at Rs 900. But your mind gets ‘anchored’ to the ‘cheaper’ price because Rs 70 is much less than Rs 900.

You think, with limited resources, you can only buy 30 shares at Rs 900. But you can buy 400 shares for Rs 70. So, you ignore your friend’s advice and buy the Rs 70 stock.

What you fail to realise is that the Rs 70 stock is actually not ‘cheap’ at all, because it is trading at a high P/E of 44; whereas, the more ‘expensive’ Rs 900 stock is trading at a much lower P/E of 16.

Sound familiar? It should. Most small investors end up making such errors in decision making due to their cognitive bias. (Yours truly is no exception. Been there, done that.)

The trick to making money in the stock market is to learn from your mistakes by documenting them and not repeating them.

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