Say I gave you a choice between two stocks. Which would you pick?
- One has seen its share price more than double over the past 12 months.
- The other is down an average of 27% per year since April 2008.
The average investor would probably chase performance and go with the winning stock. Contrarian readers would see that that was the obvious pick and go the other way, arguing that the falling stock could possibly be a better value.
But actually, it's a trick question. Both choices refer to the same investment, Bank of America (NYSE: BAC ) , which has obviously seen a lot of movement both up and down since the beginning of the mortgage meltdown.
When you focus on a particular stock price or some other financial metric, you're doing something known as anchoring. Anchoring is a behavioral response to the seemingly random fluctuations of stock prices. In an effort to impose some order on those movements, we latch onto a specific point of reference, even if it's arbitrary and has no meaning to anyone else.
Anchoring can be collective or individual. Whether the Dow would hit 11,000 was something many investors paid attention to, even if Dow 11,000 doesn't really have any particular significance. But because a lot of people pay attention to milestones, the collective response to hitting one may actually make following them worthwhile -- at least for purposes of short-term investing decisions.
On the other hand, nearly all of us are guilty of creating individual anchor points. Sometimes, it's a high-water mark that a stock sets. For years after the bull market ended, investors pined at the tech-bubble highs that Dell (Nasdaq: DELL ) and priceline.com (Nasdaq: PCLN ) had set in 1999 and 2000. In doing so, they ignored deteriorating fundamentals, such as the slowing revenue growth and stagnant net income at Dell and the big drop in revenue at priceline.com that accompanied the tech bust.
Another common anchor point is the price you pay for a given stock. Given the exact same stock with the same financials behind it, shareholder behavior may be quite different depending on when investors bought the stock. Research has shown that if you're sitting on a loss, you're much more likely to try to ride it out in the hope that the stock recovers to your buy-in point. If you have a small gain on a stock, you're more likely to sell it in order to preserve profits -- but once you have a big gain, you may want to "let it ride" in hopes of even bigger profits.
A combination of those factors may explain part of the rally in Ford (NYSE: F ) and Office Depot (NYSE: ODP ) . Despite all the great news that Ford has had lately, anyone who has owned shares since 2000 is still trying to make back losses, as the stock was 70% higher a decade ago. Office Depot shareholders are still down over 60% from 2005 levels, and the company continues to struggle against heavy competition. But anyone who bought those stocks at the market's lows of March 2009 have made so much profit that it would be almost impossible to lose money. So neither group has an incentive to sell, supporting shares as they climb higher.
Fighting the impulse
The key to avoiding the detrimental effects of anchoring is to pay more attention to actual fundamental events that have an impact on your stocks. In the case of Ford, for instance, analysis of whether Toyota's (NYSE: TM ) woes will lead to increased Ford sales is a much better way to decide whether to buy or hold onto shares than a simple desire to see the stock match its 2000 level of $23. For Office Depot, the long-term success of Staples (Nasdaq: SPLS ) represents a constant threat, and investors would be better served watching the industry's changing dynamics.
You won't be able to avoid anchoring entirely. Important calculations, such as taxable gains and losses, are based on numbers that will tend to make you think in terms of an anchor. But by being aware of potential mistakes that anchoring could lead to, you're much more likely to avoid them -- and make better investment decisions overall.
It's still a good time to buy stocks. Fool contributor Rex Moore has seven stocks that are headed in the right direction.