This Kind of Anchor Can Sink You

Anchors are necessary. Sometimes you just don't want your boat to go anywhere. Sometimes you want someone to read the news to you on TV. Sometimes you want to know what's going on at college. (The Anchor is the student paper of Rhode Island College. Go Anchormen!) But in your investing life, anchors can sometimes be a dead weight on your returns.

Picking a number
Any number of anchors can snag your portfolio, preventing it from moving forward. You could be weighed down by a tendency to procrastinate, or perhaps a fondness for rapidly jumping in and out of stocks, never giving them a chance to perform. But there's another critical kind of anchoring in investing -- a psychological barrier that springs up when we fixate on something that we shouldn't, and then draw conclusions or act based on our unhealthy focus.

Let me give an example. Let's say you read about a very intriguing company, Scruffy's Chicken Shack (Ticker: BUKBUK), whose stock is trading around $30 per share, and you add it to your watch list. A few months later, you see that it's down 33%, to $20 per share, and you get excited, thinking it's a bargain. That's problematic, because the $30 starting price doesn't really mean much by itself. The stock could have been very undervalued or overvalued at that time. If it were very overvalued, it might not yet be a screaming bargain after a big price drop. And the company might have other problems, too.

Don't be swayed
Check out the companies below. Some might think they're good buys because they've fallen so much over the past year. Yet each has earned just a single star (out of five) from our Motley Fool CAPS community of investors, posted losses over the past 12 months, and seen its revenue fall in recent years. Furthermore, none has come close to matching the S&P's 34% rise over the past year.

Data: Motley Fool CAPS. TTM = trailing 12 months.

On closer examination, they're not so exciting, right?

Similarly, you might look at a company such as Amazon.com (NASDAQ:AMZN), and see that it's up more than 235% over the past year. On its way up, some people concluded that it was overvalued, and perhaps even worth selling. But they would have been smarter to dig deeper, and look at the company without thinking of how far it had risen or fallen relative to a price on a somewhat random day.

Other anchors
Anchors wreak havoc in other aspects of our investing lives, too. For example, do you remember your overall portfolio's peak value? Probably. And you may view its current level only in relation to that peak -- "I'm down 18%." 

But that peak value is somewhat random, since stocks rise and fall from day to day. The peak value doesn't represent the actual intrinsic value of your portfolio; it may well represent an inflated value.

Instead, think about your various holdings are going, and what you expect your portfolio's value to be in the future. When you assess a stock as a candidate for your portfolio, it's more important to suss out its intrinsic value, and how undervalued the stock is relative to that.

Don't let yourself be tied down by anchoring. Just use all the information you can get to make the best decisions you can.

Joe Magyer weighed anchor with this stock and has regretted it ever since. Read about his mistake and what you can do to avoid it.