Don’t fall prey to this Behavioral Bias
Amar is a CFA Charterholder and CFP, having over 20 years of experience in IT and Financial Services. He is very passionate about spreading financial literacy and has authored four bestselling books on Personal Finance.
03 Oct, 2017
As investors, one of the most common and determinantal mistake people tend to commit, is that of binding ourselves to a certain value or price. Technically, this phenomenon is referred to as anchoring and it is a very common occurrence in the realm of behavioural finance. To explain the term simply, anchoring is when we hold onto some fact or figure and use that as a yardstick for making future decisions.
But, is also one of the most difficult to overcome and can hurt one seriously when it comes to how one thinks about money. One way to avoid it is by not allowing yourself to get caught up in the idea of what you ‘think’ something should be worth, as opposed to its actual value.
Let’s take the case of two neighbours to better understand how anchoring can really harm one’s finances. Ever since the time Mr. Harish Shrivastava sold his flat, Mrs. Preeti Saini has been having a hard time selling her own. You might think that this sounds ridiculous since the two flats belong to two separate entities. The issue that holds Mrs. Saini from selling her flat at any offered price is that she believes her flat is much better than Mr. Shrivastava’s. Concurrently, she believes that she deserves a higher price for her sale. When it comes to buying or selling real estate, this is a rather common phenomenon because both, the buyer and the seller are anchored at a price.
In the case of Preeti, it was her believing that her flat should have been valued at more than that of Harish’s. Even after months of waiting and looking around for a better offer, Preeti’s flat was eventually sold for less than the selling price of Mr. Shrivastava’s flat.
Anchoring can have a powerful impact an individual’s financial life but its adverse effect often takes place without the person being aware of it. One’s financial decisions can be seriously dented by anchoring and so, appropriate attention must be paid.
Indications of whether you’re afflicted by anchoring include:
- You prefer to buy mutual fund investments at the Net Asset Value (NAV).
- You use the Sensex as an indicator tool, to dictate your entry or exit from a stock or mutual fund.
- You buy insurance based on the premium you can afford to pay or on the basis of what others have bought.
- You look at the past performance of investments prior to making any decisions about it. This means that if over the course of four years you have received 30 per cent, you’re now mentally anchored to 30 per cent and feel that by lowering your expectation to 25 per cent, you’d be doing the mutual fund or stock a favour. This is the feeling despite the fact that the company’s earnings growth could be between 18 to 20 per cent.
- You are loyal to certain brands that might not hold a lot of relevance.
- You hold onto a number, such as your purchase price of a stock, real estate or an equity mutual fund to sell the investment. The logic this is based upon is along the lines of, “Since I have paid Rs. 45 lakhs as the initial investment, I should be able to make Rs. 45 lakhs off it”.
- You do something simply because someone in your family or within your peer group does it. An example of this is buying an expensive TV or car just because your neighbor bought the same a few months ago.
In other words, you should avoid making financial decisions based on whims, lest you end up committing some costly errors. A good idea would be to start by asking yourself a few important questions like ‘Are my expectations realistic?’. Better yet, consult a professional in the field, such as a stock market professional or a real estate broker, who would provide an unbiased and independent view on the subject. This will help you arrive at a proper decision; one that is best suited for you.
Just remember to avoid projecting your current environment onto your future, especially for indefinitely because things always undergo a change.