Anchoring

Anchoring means hitching on to a number and using that as a basis for a later analysis. Studies have found that even when the person knows the first number is baseless, it still has an impact.

One study involved having students guess how many African nations were part of the United Nations, but first they dialed up a random number and were asked if the number of member nations was higher or lower than that number. If the number dialed was 65, the guesses might have been lower but the number of nations guessed was 45, when ten was dialed, the average guess was 25.

Foreign merchants know about this. You get the "foreigner discount" at the market in Bali, and you know the initial asking price is way too high. But you don't know what the real price is. If a merchant told you $50 you would think the item fairly priced at $10, but if he started you on $20, you would think it worth $5.00. This is simple anchoring.

Another study tracked the valuations of a property by two groups of valuers. Each group valued the same house, and was given an identical information pack showing sales data in the area. The two groups were told the house was listed at a certain price, but each group was told a different figure. Although the valuers said the list price had no effect on their valuation reports, the group that was told the higher listing price gave a mean valuation $7,000 higher than the group told the lower listing price.

The same phenomenon applies to stock valuations. If the stock traded at $10 per share previously, you assume it is now undervalued at $5.00. If that same stock was $20 before you will think it undervalued at ten. Stock valuation is as much an art as a science, but often previous values can be nonsensical. Even if you build up your own value model completely independently of price, simply from cash flow models or discounted dividends, the old price may still have an effect.

It is hard to bring oneself to buy a stock making a new high, but of course any stock that is on its way up ought to be doing this on a regular basis. Many will feel the stock is overpriced and not buy, simply because they are more used to it costing less. Anchoring also affects bottom-fishers who cling to the old price and feel that this price may return. Simply, the old price is gone and in the past. It is not a reflection of worth, do not use it to come up with your valuations. Ideally you should operate in total ignorance of the stock price while making your analysis, and then come up with a number. If you check the market quotation and are pleasantly surprised, buy it. Otherwise don't buy it.

Anchoring to an old purchase price also is something that stops many people from selling stocks now showing a loss, they simply feel it is too cheap to sell now. It also inflates the value of other stocks now trading well below their all-time high. People see that as a point the market has valued the stock at before, and feel it more-or-less inevitable that the stock will climb above that point some time in the future.