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The Psychology of Investing, Part 2 What's My Anchor?

By David Gardner

Editor's Note: The following article is part of an ongoing series on the Psychology of Investing and was initially run as a Rule Breaker Portfolio report.

Part of cognitive science's discovery -- or contention, if you like -- is that we are all operating under certain "cognitive illusions," which are consistent errors in reason that occur instinctively in all of our minds -- all humans across all cultures. It's simply the way our brains work. We go down certain "mental tunnels" over and over, in many cases without even being conscious of doing so -- or that there was any other way.

Let me start this second installment of "The Psychology of Investing" -- where we try to overcome cognitive illusions when thinking about our money -- with an exercise Piattelli-Palmarini tosses out on page 45.

OK, I'm about to put a mathematical operation before you. You have exactly five seconds (have someone time you) to estimate the product below (don't look yet). Unless you are a flat-out genius, you won't have enough time to multiply all these numbers together, so you'll probably have to estimate the answer.

2 x 3 x 4 x 5 x 6 x 7 x 8

STOP!

(What, you don't have a light pen or a touchscreen monitor?!)

Nice.

Now, find a friend. (Perhaps it's the person who timed you.) You're going to show your friend another mathematical operation, to which he or she will have exactly five seconds to come up with an answer (same conditions). Ready?

Go.

8 x 7 x 6 x 5 x 4 x 3 x 2

Stop. Fill in their answer (their best guess) here: ___________

The game is over. Now, let's learn.

First of all, reasonably discerning people who are not utterly terrified of numbers will note that the answer to both of the above problems is identical. The multiplicands (man, I haven't used that word since grade school) are simply ordered differently.

However, in the vast majority of cases (and you can verify this by trying it on a whole group of people), the number filled in to answer question #1 is well below the one to answer question #2. Perhaps the reasoning is evident, but here it is anyway.

As one goes quickly through the mental machinations, one instinctively starts on the left and goes right. The first three numbers on the left of question #1 are: 2, 3, 4. You might have gotten to 24, there, and then have to make a shot-in-the-dark guess at what the final numbers would take you to. Question #2, posed to your friend, begins with the following first three numbers: 8, 7, 6. Your friend might have gotten to 300 or so, and then had to do some quick math to estimate his answer.

Given the difference between 24 and 300, any surprise that the second response is typically far higher?

But what is going on here?

Cognitive science and psychology say: Anchoring.

Anchoring is the second cognitive illusion we'll look at. It is closely related to "framing," which was the subject of our first installment of "The Psychology of Investing." Framing shows us that the way we are presented information determines our reaction to that information. The cognitive illusion in play there -- the mental tunnel -- involves a laziness in our thinking, as our shortcut-taking brains prove unwilling to rearrange the information and present it in a different way.

Anchoring is related to framing, because it involves the way that information is arranged. Anchoring tells us, as Piattelli-Palmarini writes, that our brain "remains anchored to the first product we obtain. We seem never to stray far from that -- or never far enough. It is as though we were unable to forget our first estimate."

The implications of this are deep, even disturbing. It points to the human mind's possible inability to take in external sensory data in a balanced and complete way, and evaluate it fairly. Instead, our minds latch on to information:

1. in the way it is presented...
as opposed to other ways it might be presented

2. in the way that we have preconditioned ourselves to view it...
as opposed to what it "actually" says
The mathematical exercise above is an extremely clear demonstration of the reality of "anchoring" in all of our minds.

Now let's take this notion of anchoring and imagine some of the ways it affects us and our money.

Here's one thing that occurs to me:

It has been far more difficult for the Depression era generation to move its money into stocks. My grandparents were "anchored" in the belief that the market was risky and might crash again at any time. Business was undependable, the government was more dependable, and government-backed securities were by far the choice over stocks. (That created a strong -- I believe too strong, to the point of being harmful -- reliance on government and the public sector.)

Rather than 2 x 3 x 4 x 5 x 6 x 7 x 8, substitute other numbers like these (simulating market percentage returns being tossed out at investors):

-15, +6, -10, -22

An entire generation was anchored to expectations like that from the stock market, undermining confidence in the business world at large. That's the natural result that came of psychological anchors established during one's adolescence or early adulthood (those impressionable years) in the Depression.

I mean, really: If those were the market's percentage returns in the first four years of your investing, would you be as excited about investing in the stock market as you might be today?

(A corollary consideration: Should you be as excited to be invested in the stock market as you are today?)

+37, +23, +33, +28

Do you know what? Those last four numbers are in fact the S&P 500's percentage returns (including dividends) over 1995-1998. So today's environment is creating young adults and new investors who are probably (are we?) anchored to a very different shore. We are anchored to the notion that the stock market is a good and strong thing, that stocks go up more often than not and make their investors rich, that business and technology are more productive than government.

I actually believe this is a good anchor. (Not all anchors are incorrect or bad; no rules against anchoring to a correct notion.) I believe that technology is driving business, and business is driving our culture. Government is increasingly irrelevant, which is a good thing, which was in fact the vision of America's "Founding Fathers." Free markets and capitalism are wildly preferable to what came before, and today's stock market loves the implications of that more productive future. The world is shifting toward democracy and an unprecedented spread of capitalism.

That said, one can err by overstating these ideas -- anchoring to unrealistically good expectations. Are you doing this?

I'll tell you of some people I think are. I think many momentum players and daytraders are anchored to the notion that stocks will keep going up and that you will make lots of money by trading them.

Truly, though, the only sure thing here about trading is that you will pay lots of money to do it. Whether or not you make money comes down to whether the market and your stocks rise. And if the market and your stocks rise, is it not more effective to buy and hold through that? I don't know of a single study yet that has supported the notion that anyone can accurately time the market or consistently "know" where a stock is headed over the short term. Anyway, the anchoring going on for some elements of today's generation, those reading Electronic Daytrader guides, is that this is a good way to invest.

Come any sustained bear market, we may see some people returning to productive work!

In each part of this "Psychology of Investing" series, I can't do much more than just present a couple applications or thoughts about a given cognitive illusion. The rest is up to you. In this case, once you understand anchoring, you are better prepared to escape that cognitive illusion in your own investing and in life by being conscious of it.

The goal for any investor -- any human being, actually, in any context -- is to take information in and evaluate it rationally and objectively, to produce the best results. To do so, we must avoid traps like framing, the bias created by how information is presented, and anchoring, the bias we impose upon information, ourselves.

Next -- Tails-Tails-Tails-Tails

The Psychology of Investing

• Part 1 -- Overcoming Fallacious Thinking As an Investor
• Part 2 -- What's My Anchor?
• Part 3 -- Tails-Tails-Tails-Tails
• Part 4 -- Are You Checking the Box?

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