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Why Living In The Past Can Be Risky

Here’s a common scenario which happens in investing. This was shared by New York Time columnist Carl Richards on our Fool US site:

“You buy a stock for $50 a share, and six months later it’s $30. You decide that you really shouldn’t own it anymore but you want to wait until you “get back to even” before you sell.”

Mr. Richards goes on to say that the fact that you paid $50 for a share — in the scenario above — should not influence what you do next. With it, he hit upon a psychological bias which exists in all human beings. This bias is one which is often referred to as “anchoring”

But, what is anchoring?

Anchoring is the human tendency to rely heavily on the first piece of information offered (an anchor) when making a decision. In the case of investing, the anchor typically would be the share price that you paid for the company. My colleague, Ser Jing, also talked about anchoring bias in an earlier article.

A tale of two companies

Below is the share market returns for Dairy Farm Holdings International Ltd (SGX:D01) and Global Yellow Pages Limited (SGX:Y07) from mid-December 2004 to 8 October 2014. From this view, it truly has been a tale of differing fortunes so far for the duo.

anchoring graph 1

Source: Google Finance; Dairy Farm (Red), Global Yellow Pages (Blue)

From 17 December 2004, the share price for Global Yellow Pages has shrunk by 97.4% while the share price of Dairy Farm rose by 278%. Let’s take a step further, and consider the trailing twelve months earnings-per-share (EPS) on 8 October 2014 against the original share prices on 17 December 2004. In this case, the price to earnings (PE) ratio for Global Yellow Pages would have ballooned to 295 against the share price of $1.71 on 17 December 2004. Meanwhile, the PE ratio for Dairy Farm would has dwindled to less than 7.

Company Share price (17 December 2004) Share price (8 October 2014) Trailing 12 month EPS PE ratio on 17 December 2004
Global Yellow Pages $1.71 $0.044 $0.0058 295
Dairy Farm US$2.52 US$9.55 US$0.3738 6.7

Source: Bloomberg, Google Finance

How anchoring can works against you

Consider an unfortunate individual investor invested in Global Yellow Pages in 17 December 2004. In this case, it may well be a very heroic assumption for him or her to assume that the company’s share price return to $1.71 anytime soon. In fact, the underlying business for Global Yellow Pages is slowly changing, as my colleague Sudhan notes here. As such, “waiting to come out even” might not be the best course of action.

On the other side of the coin, fortunate individual investors of Dairy Farm who purchased its shares on 17 December 2014 may also face anchoring bias — but for a different problem. In this regard, with the original purchase price spotting a low PE ratio of 6.7, would it be a reasonable expectation to wait until the share price drops below their original purchase price?

The original purchase price, in this case, might not add anything useful to the thesis of the company going forward. Foolish investors may be better served by considering the merits of Dairy Farm from this day forward, and deciding whether today’s price is worth their investment dollars.

Foolish Take away

As long term Foolish investors, our greatest advantage is in learning about a company over time. It could be helpful to keep a journal on what you have learnt about a company so far. This documentation could include quarterly recording of simple ratios like the EPS, or the trailing twelve free cash flow to track the growth of the company’s value over time.

In times of short term duress, this document — in which we list down the company’s strengths built up over the its lifetime — could come in handy as it would help remind us of why we bought the company in the first place. Meanwhile, the recorded ratios can also help us determine if there is an opportunity based on the most updated value of the company, as opposed to looking at changes in share price alone.

If the Foolish investor can turn towards tracking the change in underlying value of a company instead of the share price, he or she may stand a better chance at pushing back on the effect of anchoring bias.

With it, an advantage over the market might just be gained.  If you’d like to learn more about investing, sign up for a FREE subscription to The Motley Fool’s weekly investing newsletter, Take Stock Singapore. Take Stock Singapore will keep you up-to-date on the latest stock news and teach you how you can GROW your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.