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Stop Your Brain From Hurting Your Returns

Ser Jing - Here's A Better Way to Think About Investing (pic)

Here’s a simple math problem for you: A candy bar and stick of gum together cost $1.10. The candy bar costs $1 more than the gum. Quick: How much does the gum cost?

Before we get to the answer, let’s talk about one of the most common investing questions out there: “Is this still a good price to buy this stock?” Or, put another way, “Did I miss the boat on this stock?” We often ask this when a stock’s price has climbed recently or is sitting near a 52-week high.

Behind this question lies a psychological bias that keeps many investors from landing fantastic returns. It certainly seems natural to compare a company’s current price to a lower price in its past; after all, we’re always hunting for bargains. But what’s really happening is something called “anchoring” — and when it comes to investing, anchoring can really hurt you.

Stuck stuck on a number number

Anchoring is letting one number influence your thinking about another. And we all do it without even realizing it.

Here’s an example from Jason Zweig’s book, Your Money and Your Brain. In it, Zweig asks you to take the last three digits of your phone number, then add 400. Then he asks two questions: Taking the number you just got, was Attila the Hun defeated in Europe before or after that year? And what’s your best guess of the exact year Attila the Hun was defeated?

Zweig goes on to reveal data from hundreds of experiments showing that even though phone numbers have nothing to do with battles against medieval barbarians, the average guess marches upward in lockstep with the anchor:

Last 3 Digits of Participant’s Phone Number Plus 400

Average Estimate of When Attila Was Defeated

400 to 599

A.D. 629

600 to 799

A.D. 680

800 to 999

A.D. 789

1,000 to 1,199

A.D. 885

1,200 to 1,399

A.D. 988

When your brain seizes on a number, writes Zweig, it becomes stuck, “as if it had been coated in glue.” That’s why real-estate agents often show their clients the most expensive house on the market first — the others will seem cheaper by comparison.

(The correct answer, by the way, is A.D. 451.)

How we anchor as investors

Returning to investing, when we first come across a stock idea, we often first check recent prices. If the price has declined over the past few months, we anchor on the higher price as “better times” and worry that there’s something wrong now. Or we might see the lower price as a bargain, again anchoring.

If, instead, the price has climbed, we might wait for a pullback, anchoring again (call it “missed boat” syndrome). And if the price is near an all-time high, we worry that the price cannot go higher, anchoring as if that’s an impenetrable ceiling.

The game is rigged. Our brains can’t help doing it, and it’s working against us. Not convinced? Let’s get back to the math puzzle that kicked this whole thing off. What was your answer for the price of gum?

If you answered $0.10, which the vast majority of people do, you anchored on the two numbers mentioned in the problem — and you’re wrong. If the gum costs $0.10, the candy bar must cost $1.10 — but together, that’s $1.20. Think about it, and you’ll realize that the gum cost only $0.05.

What you can do about it

So if we anchor without realizing it, how can we minimize the damage? Here are three tips.

1. Ask yourself, “Will this investment beat the market over the next three to five years from today?”

Regardless of what a stock has done in the past, the key question is, what’s it going to do next?

Conglomerate Jardine Strategic Holdings (SGX: J37) had already gone up more than 500% in five years from US$2.60 on Jan 2003 to US$15.90 on Jan 2008. But any investor who asked himself if the company can continue to beat the market from that point onward, answered ‘yes’, and then promptly invested, he should be very happy now.

Jardine Strategic currently trades at around US$32.00, giving its shares a 101% gain since the start of 2008. Meanwhile, the Straits Times Index (SGX: ^STI) has gone from 3,440 points to 3,070 points for a 10.7% decline in the same period, having convincingly lost to the conglomerate.

Today, investors still need to ask that same question, ‘What’s it going to do next?’

2. Stop paying attention to meaningless barriers like all-time highs.

What happens going forward is what matters — not a price that a stock supposedly cannot break through. We’ve already seen that in action with Jardine Strategic Holdings.

Shares that go on to make multi-bagger returns often hit multiple new all-time highs. That’s how a healthcare operator like Raffles Medical Group (SGX: R01) can go from a market value of S$104m at the start of 2003 to S$1.69b today. It had to traverse multiple peaks to get to where it is now.

3. Don’t make snap judgments.

Fast answers are often wrong, as you saw with the “gum” question. Give your brain time to catch up and let some actual thought in. Writing what we’re thinking in an investment journal helps slow us down so that we can avoid making snap judgments.

Here’s an example from America. Many people who sized up the competition between online retail juggernaut Amazon.com (NASDAQ: AMZN) and brick-and-mortar retailer Best Buy (NYSE: BBY) figured the former would crush the latter.

Yet new Best Buy CEO Hubert Joly has implemented a strategy to turn the company around. It includes “stores within a store” featuring Apple and Samsung products, a low-price match guarantee, and a reduced corporate head count — and it appears to be gaining traction.

The company reported a profit for the last two quarters and actually saw a slight same-store sales gain last quarter after a string of declines. Whether Best Buy ends up coming back from the brink depends on how well it follows through with what it has done so far and how else the company can deliver value to its customers. The snap judgment that Best Buy was doomed has, so far, turned out to be wrong.

Foolish Bottom Line

Keep anchoring in mind and do what you can to avoid it, and you’ll do better as an investor.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. This article was written by Jim Mueller and first published on fool.com. It has been edited for fool.sg.