By now, you’ve probably heard the news: our own behavioral biases are often the greatest threat to our financial well-being. As investors, we leap before we look. We stay when we should go. We cringe at the very risks that are expected to generate our greatest rewards. All the while, we rush into nearly every move, only to fret and regret them long after the deed is done.
Most of the behavioral biases that influence our investment decisions come from mental shortcuts we depend on to think more efficiently and act more effectively in our busy lives. Usually, these short-cuts work well for us. They can be powerful allies when we encounter physical threats that demand a reflexive reaction, or even when we’re simply trying to tackle the countless decisions we face every day. But when it comes to investing, these behavioral biases can do more harm than good.The first step in overcoming these potentially dangerous behavioral biases is to be aware of them in the first place. One of the biases I see most frequently as a financial planner, especially when I am meeting with a client for the first time and we are reviewing an existing investment portfolio, is a behavior called anchoring.
Anchoring bias occurs when you fix on or “anchor” your decisions to a reference point, whether or not it’s a valid one. In investing, people often anchor on the price they paid when deciding whether to sell or hold a security: For example, “I paid $11/share for this stock and now it’s only worth $9/share. I’ll hold off selling it until I’ve broken even,” or “I bought that piece of land for $30,000 and today it is only worth $12,000. I won’t even think of selling it until it bounces back and I can recoup my initial investment.” Sound familiar?
As an evidence-based investor, we understand intuitively that an investment portfolio should be comprised of vehicles that are consistent with our overall financial plan; investments that are well-diversified and that play a specific and integral role to our overall investment strategy. If you wouldn’t buy the investment today, regardless of the price, because it doesn’t have a place within your low-cost globally diversified portfolio, there is no reason to continue to own it. What you paid is immaterial to that decision, so anchoring on that arbitrary point creates a dangerous distraction. That being said, there is one caveat to consider: if there are tax considerations which need to be taken into account, getting out of a position in a tax-effective manner would be most prudent.
Anchor points can be helpful when they are relevant and contribute to good decision-making. For example, if you’ve set a 10 pm curfew for your son or daughter and it’s now 9:55 pm, your offspring would be wise to panic a bit, and step up the homeward pace. But when the anchor point is irrelevant, the only purpose it serves is to tempt you as an investor to make irrational decisions. So, now take a look at your portfolio – be sure that it is comprised solely of investments that serve a purpose and that will bring you closer to reaching your goals. Don’t let your anchoring bias weigh down the growth potential of your portfolio with unnecessary risk.