Ever wondered why stores bother to quote the 'recommended retail price' on the products they sell, particularly if they're now available at a massive discount? It's quite simple. Showing their customers what they would have paid before the discount was applied makes it more likely the latter will assume they're getting a great deal. This can work even in situations when a discount isn't initially mentioned but where a bit of negotiation is expected, such as when we employ the services of a tradesman. By establishing a high opening price, an informed tradesman knowingly fixes the starting point for bargaining to begin.
In the scenarios above, both the retailer and the tradesman recognise our tendency to use anchors whenever we're required to estimate value. In other words, we take something we know to be true (such as the RRP) and use this as a guide for how much we should pay. Assuming everything goes to plan, the buyer will always be satisfied if the final price is lower than the initial price. And of course, the store or tradesman will also get the price they originally wanted or expected.
Unfortunately, our susceptibility to using anchors can be problematic when it comes to investing.
Time to buy?
Have you been tempted to buy shares after a sudden and substantial drop, hoping they'd recover soon afterwards? Perhaps you've been drawn to companies such as Laird, GB Group and NCC, all of whom have seen their shares prices plummet over the last few weeks.
The trouble with this approach is that our devotion to historical share prices might lead us to assume that every steep drop is an investment opportunity. While this may be true if the dip was the result of general market jitters, it might not be the case if it had anything to do with the company in question, such as a contract loss or profit warning.
This isn't the only way anchoring can send us off course. Our tendency to base decisions on fixed (but ultimately subjective) values can also mean we ignore an undervalued company in favour of one that is substantially overvalued. It can lead us to overestimate our investing prowess if this year's returns were better than the last. It stops us from investing in a great stock because our target price is too low or from selling a holding because our asking price is too high.
So how can investors protect themselves?
Stick to the facts
The first step to mitigating the effects of anchors is simply to become aware of how remarkably easy it is to employ irrelevant information when making important investment decisions. A falling share doesn't always recover its previous highs.
Second, it's vital that our evaluation of any company rests on its fundamentals and not just the behaviour of its share price or how it scores on a few self-selected ratios. It would also help to consider the shares from a variety of perspectives, including that of someone keen to relinquish their holding. After all, for every buyer there's always a seller.
Third, we shouldn't rush our investment decisions, especially if we suspect they may be based on emotions. Thorough research and hard facts should always trump gut feeling.
Ditch your anchors. They'll only weigh you down.
Your worst enemy
Learning the identity of your greatest adversary is one of biggest challenges in investing. It's not other private investors, day traders or the big institutions. Rather, it's likely to be the very person staring back at you in the mirror.
Unfortunately, anchoring is just one of many bad habits investors can slip into. If you're keen to avoid making expensive errors in your investing career, I strongly suggest you read a special report produced by the experts at the Motley Fool. The Worst Mistakes Investors Make contains some excellent hints and tips on how you can avoid making the most common blunders.
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Paul Summers has no position in any shares mentioned. The Motley Fool UK owns shares of NCC. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.