Anchoring and Adjustment

Anchoring and Adjustment is a powerful Cognitive Bias and mental shortcut (a `Heuristic`) that describes our tendency to rely too heavily on the first piece of information we receive—the “anchor”—when making decisions. First described by the psychologists Daniel Kahneman and Amos Tversky, this bias shows that once an anchor is set in our minds, we rarely adjust our estimates far enough away from it, even in the face of new, contradictory information. Imagine someone asks you to guess the percentage of African nations in the UN. But first, they spin a “wheel of fortune” that lands on either 10 or 65. Those who see the number 10 guess a much lower percentage than those who see 65. The initial number, though completely random, has anchored their judgment. In the world of investing, this bias can be a portfolio's worst enemy, tethering your decisions to irrelevant numbers rather than to a company's true worth.

For investors, anchors are everywhere, and they can be dangerously persuasive. They create a psychological benchmark that can distort your perception of value and lead to irrational choices that are completely at odds with a sound Value Investing strategy. Recognizing these anchors is the first step toward freeing yourself from their influence.

This is perhaps the most common and destructive anchor for the average investor. When you buy a stock at $100, that price becomes a powerful mental anchor.

• Refusing to Sell Losers: If the stock drops to $70, you might refuse to sell, thinking, “I'll just wait until it gets back to what I paid for it.” Your decision is anchored to your purchase price, not the company's deteriorating Fundamental Analysis or its declining Intrinsic Value. You're waiting for your ego to be salvaged, not for the investment case to improve.
• Selling Winners Too Early: Conversely, if the stock rises to $150, you might be tempted to sell and “lock in a good profit.” The anchor at $100 makes a 50% gain feel like a massive win, even if a careful analysis would show the company's prospects are better than ever and its intrinsic value is actually closer to $250.

Every financial website and trading app displays a stock's 52-week price range. This readily available data point is a notoriously misleading anchor. A stock trading near its 52-week low is not automatically “cheap,” and one near its 52-week high is not automatically “expensive.” A business's value can change dramatically over a year. A low price may reflect a truly broken business, while a high price might still be a bargain if the company's growth has been spectacular. Anchoring to these arbitrary highs and lows is a substitute for the real work of valuation.

The very first piece of data you encounter about a potential investment can set an anchor for your entire analysis. This could be:

• An analyst's bold price target you read in a headline.
• The stock's Market Price the first time you look it up.
• A high P/E Ratio that immediately makes you think “expensive” before you've even considered the company's growth rate or industry.

Once this initial number is lodged in your brain, it can be difficult to assess new information objectively. This is often magnified by Confirmation Bias, where you subconsciously start looking for reasons to justify your initial, anchored impression.

The good news is that while anchoring is a natural human tendency, it can be overcome with discipline and a structured process. A value investor's primary defense is a relentless focus on business value over market noise.

• Focus on Business Value, Not Market Price: Train yourself to think like a business owner, not a stock trader. Your primary question should always be, “What is this entire business worth?” not “Where has the stock price been?” Calculate your own estimate of intrinsic value based on earnings, cash flow, and assets. This creates a rational anchor to replace the market's irrational ones.
• Start from Scratch: When re-evaluating a stock in your portfolio, make a conscious effort to ignore your entry price. Ask yourself the crucial question: “Knowing everything I know today, would I buy this stock at its current price?” If the answer is no, you should probably sell, regardless of whether you're at a profit or a loss.
• Seek Disconfirming Evidence: Actively fight your own initial impressions. If you've anchored on the idea that a company is a fantastic buy, make it your mission to find the most intelligent bear case against it. This forces you to challenge your anchor instead of reinforcing it.
• Use a Pre-Mortem: Before buying a stock, conduct this powerful mental exercise. Imagine it's one year from now and the investment has been a total disaster. Write a story explaining all the reasons why it failed. This helps you see potential risks you might have overlooked because you were anchored to an optimistic outlook.
• Create Your Own Anchor First: The ultimate technique is to turn the tables on the bias. Before you look at the current stock price, an analyst's opinion, or even a price chart, do your own homework. Research the business and come up with your own estimate of its value. Your independent, well-reasoned valuation becomes your anchor, making you far less likely to be swayed by the market's whims.