‘Nobody makes money by investing in stocks’. We hear such statements quite often from people. Equity, as an asset class, brings negative emotions in the minds of a large number of people, due to which they decide to stay away from it. Chief among the reasons is a bias among investors popularly known as ‘anchoring’.
What is ‘anchoring’?
www.sciencedaily.com defines anchoring as:
Anchoring or focalism is a term used in psychology to describe the common human tendency to rely too heavily, or ‘anchor’ on one trait or piece of information when making decisions.
Investors tend to give undue importance to an event and justify their decisions with reference to that event even though it may,in reality, be of little relevance. Very often, the anchor is linked to a price. Among the most common anchors linked to the market values are the previous market top (just before a huge drop), the previous market bottom (after which a huge rally started), and all-time high for the market. There are anchors related to the price of individual securities, too. In this article, we will look at one of the anchors related to the market price ‘the all time high so far’ and discuss how that may contribute to the overall fear in the minds of most.
We took daily closing values of Sensex for the 8,892 trading days from January 2, 1980 till September 30, 2018.
The next thing we did was to mark the dates on which Sensex closed at a new all time high. These are the anchors – we have assumed that investors would set the anchor at the all time high levels of Sensex. Once a new peak is scaled, that would become the new anchor, the all time high so far.
After doing this, we checked whether the Sensex closed above this level on each trading day. The number of times Sensex closed below the ‘all time high value so far’ was counted.
It turns out that during the period observed, Sensex has closed below the “all time high so far” on a whopping 8,304 days, out of 8,892 days – or on 93.39% of the days.
Though this number looks so big, it should not come as a surprise, think about it. Sensex values fluctuate and do not move up in a straight line. There are many ups and downs and there have been long periods of negative returns.
Now combine the above statistics with the anchoring bias and you get some interesting results. If people anchor at the all time high value (and it is not new: even today, many still remember the peak scaled in the year 2000 or in the year 2008. Some would even remember the 1992 peak of Sensex), on more than 93% times, the Sensex for the day would be lower than the anchor.
There is a reason to believe that the investors are likely to feel there is no money to be made in equities.
There are two reasons why this anchor tends to become very strong:
- A large number of investors tend to invest near the peak of the market. Now, this is a chicken and egg question. Do investors flock to the markets when the prices are high, or do the prices reach such levels because the investors flock to buy? Whatever the reason, if an investor has invested money near the top of the market, that level remains etched in the memory.
- Media also highlights the high levels of the markets highlighting how investment in equity has handsomely rewarded the investors.
What is the way out?
Well, first of all it is human to have biases. It is natural. However, it is also important to identify our own biases and periodically question these. For an advisor, it is important to learn about various biases that the investors may hold.
Anchoring bias is probably one of the most easily identifiable biases. Among the anchors, the “all-time-high” is also an easy to remember one, since a large number of transactions (purchases, in particular) happen closer to the high. ‘All-time-high’ also attracts a lot of media coverage.
Put things in perspective and bust the myths that create such biases. Highlight that all the previous “all-time-highs” have been surpassed as the markets progress forward. Also highlight the fact that the index value is cumulative and hence so long as the economy progresses, the long term trend is upwards.
Having said that, the short term could be downward, as we have repeatedly seen and scary. Ensure your clients have properly funded their short-term requirements.
The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.