One of the common behavioral biases is anchoring. Anchoring is basing expectations and viewpoints on previous, often recent, information. An example would be the yield on the 10-year Treasury note. The benchmark bond yielded 1.59% today. If it were to rise over the short term to, say, 2.0%, your opinion would likely be that rates have jumped even though a 2.0% yield would still be lower than it was a year ago. The human mind focuses more on the available information (e.g., today’s yield) than on information requiring more cognitive effort to access (e.g., the yield from 12 months ago).
Anchoring has been long believed to influence many of our financial decisions. Though it can be replicated in experiments, its effect is harder to prove in real-world environments. Two researchers found a creative way to prove anchoring occurs when decisions have a direct monetary effect: They analyzed decisions made by contestants in the game show Jeopardy!
Jeopardy! primes contestants with actual dollar values. Every clue is preceded by a dollar amount. A contestant could choose to take “Sports” for $800, for instance. A correct answer immediately increases a contestant’s winnings by the specified dollar amount, while an incorrect answer decreases winnings. Hidden in the board are three special clues, called “Daily Doubles.” Daily Doubles allow a contestant to chose to wager any amount up to his or her entire account balance or the largest dollar value on the board, whichever is bigger. A contestant does not know if a clue is a Daily Double until a category and wager amount is chosen (e.g., World History for $600). This fact makes Daily Doubles interesting from the standpoint of behavioral economics.
Here’s why. It is in the contestant’s best interest to ignore the stated dollar value completely and bet solely based on the expected outcome. The expected outcome in this case being the maximum profit adjusted by one’s confidence in posing the correct question. (The game show requires that all answers be posed as questions, not statements.) As such, there is a record of measurable outcomes showing how people adjust their money wagers in relation to a guided amount when sizable dollar amounts are risk. The average winner takes home nearly $20,000 in prize money.
Adding to the strain on cognitive resources is the pressure aspect. In addition to the potential loss of prize money, contestants have to make decisions quickly. They also have to do it in front of cameras. Jeopardy! is the second-most popular show on television.
Given all of this, what do Jeopardy! contestants do? “More than half of all wagers fall within $500 of the initial dollar amount and over 76% fall within $1,000, even though the maximum possible wager averages $5,914,” concluded the study’s authors after analyzing 12,596 Daily Double clues. In other words, contestants anchor their Daily Double wagers based on the suggested dollar value of the clue.
Such behavior wouldn’t exist if contestants were the profit-maximizing beings (aka, “rational agents” or “econs”) much of economic theory holds them out to be. A profit-maximizing being would bet the largest amount possible based on his or her confidence in answering correctly. Similarly, a profit-maximizing being would base all investment decisions on the weighted probability of increasing wealth relative to the weighted probability of decreasing wealth. The prevailing price of a security or an index does not factor into the calculation beyond its role in calculating valuation ratios such as price-earnings ratio or yield. Even a rational agent who uses technical analysis would focus on the chart pattern and not the price listed on the Y (vertical) axis.
However, actual human behavior is far from this ideal. We anchor our expectations based on recent and past information, rather than assessing an investment’s outcome based on its current characteristics. Similarly, we view our portfolios relative to their value the last time we looked, as opposed to being focused on our process.
It’s not easy to avoid anchoring. Even being aware of it doesn’t keep you from succumbing to it. You can limit its influence by having a defined process for reviewing your portfolio and making portfolio decisions. A checklist works great for this. It also helps to be patient when making decisions and postpone taking actions when you feel rushed. Unlike Jeopardy!, no music will play while you wait to answer the clue of “the smartest financial decision I can make.”
- 15 Short-Cuts and Biases That Lead to Bad Investment Decisions – Anchoring is just one of several behaviors that can harm your portfolio.
- Managing the Mental Aspect of Investing – Suggestions on how to prevent behavioral errors from influencing your investment decisions.
- The Traits and Processes That Lead to Better Forecasts – One characteristic the best forecasters share is the ability not to anchor their viewpoints, as Phil Tetlock explains in this month’s AAII Journal.
- The Sound of Silence: Speaking to the Heart of Money Management – Sharing your views on money and investing with your family can lead to healthier relationships and a better lasting legacy.
Wayne Thorp will share insights on how to select stocks for value and growth portfolios with our Puget Sound chapter next Saturday, September 17.
The only S&P 500 member scheduled to report earnings is Oracle Corp. (ORCL), on Thursday.
The week’s first economic report of note will be August import and export prices, released on Wednesday. The Bureau of Labor Statistics’ August Producer Price Index (PPI), August retail sales, the Philadelphia Fed’s September business outlook survey, the September Empire State manufacturing survey, August industrial production and July business inventories will be released on Thursday. Friday will feature the August Consumer Price Index (CPI) and the University of Michigan’s preliminary September consumer sentiment survey.
Two Federal Reserve officials will make public appearances: Atlanta president Dennis Lockhart and Minneapolis president Neel Kashkari. Both will speak on Monday.
The Treasury Department will auction $24 billion of three-year notes and $20 billion of 10-year notes on Monday and $12 billion of 30-year bonds on Tuesday.
- Retiree Portfolios and Warren Buffett’s Allocation Instructions
- High Buyback Yields
- Advocating the Paycheck Strategy for Lifetime Investing
The proportion of individual investors describing their short-term outlook for stocks as "neutral" is at its highest level in a month, according to the latest AAII Sentiment Survey. Optimism rebounded, while pessimism fell.
Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded by 1.1 percentage points to 29.7%. This is the third consecutive week that optimism is below 30%. It is also the 77th week out of the past 79 with a bullish sentiment reading below its historical average of 38.5%.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose by 1.9 percentage points to 41.8%. Neutral sentiment was last higher on August 3, 2016 (43.4%). The rise keeps neutral sentiment above its historical average of 31.0% for the 32nd consecutive week.
Bearish sentiment, expectations that stock prices will fall over the next six months, fell by 3.0 percentage points to 28.5%. This week’s decrease puts bearish sentiment back below its historical average of 30.5% for the ninth time in 10 weeks.
The NASDAQ’s record highs did not have a significant impact on individual investor sentiment. One reason why is that the record highs occurred during the latter half of the survey period. Likely playing a bigger role are concerns about valuations and/or the presidential election. Also keeping some individual investors bearish, or at least giving them reason to be cautious, are global economic uncertainty and disappointment with corporate earnings growth. Giving other individual investors reason for optimism are this summer’s rise in stock prices, the perceived lack of investment alternatives, corporate earnings and sustained, albeit slow, economic growth.
This week’s special question asked AAII members how big of an impact international events are having on their outlook for the U.S. stock market. Nearly two out of three respondents (62%) said that international events are having no or very little impact on their outlook for U.S. stocks. Nearly 18% said that international events are negatively influencing their outlook.
Here is a sample of the responses:
- "Very little at this time. I am more concerned with the presidential election.”
- "The U.S. is still the best house in the neighborhood.”
- "I believe international events will only have a short-term impact on our economy/markets.”
- "None. The Federal Reserve is holding interest rates low, which is encouraging investment in equities.”
- "They have some impact as they impact our economy.”
Bullish: 29.7%, up 1.1 points
Neutral: 41.8%, up 1.9 points
Bearish: 28.5%, down 3.0 points
Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Local Chapter Meetings
September 1, 2016 The Impact Returns Have on How Much You Should Save
August 25, 2016 Taking on Risk and Hoping the Strategy Doesn't Backfire
August 18, 2016 A Request to Parents of Gen Xers and Baby Boomers
August 11, 2016 Using ETFs to Identify Quality Stocks
