- “Market Anchoring” is a classic case of irrational behaviour which can cost traders dearly.
- It describes our tendency to become “stuck” on a particular reference point for making judgements and stock decisions
- It serves as a lesson that most of traders’ problems come down to behavioural biases.
Anchors keep our mind fixed to the one spot because they are a reminder of what was originally a good idea. For example, we may anchor a trade around our entry point of a stock because the price “looked good at the time”.
A common example of this is a trader who, after buying a stock which has fallen in price, a losing trade, sticks to their entry point as a signal to exit.
Owning up to a loss is difficult and many traders latch onto their breakeven point in hope. Come hell or high water they refuse to sell until they break even!
The risk is that while you’re waiting for a losing stock to come back to breakeven, you may be waiting for something that isn’t coming – and magnify your losses exponentially. This can be especially disastrous if you are leveraged into the stock via a margin loan or CFD.
Traders with a winning mindset can accept a trading loss, a virtue separating them from poorly performing traders. Successful traders avoid anchors by listening to the market, admitting they’ve made an error in judgment and enacting their trading plan.
Traders with a losing mindset attach themselves to a desired exit point, neglecting their trading plan and important mechanisms behind the market: demand and supply go out the window, as the trader focuses on the anchor level.
Markets change and even the best traders will get it wrong – in most cases quite often. What looked good in the past may not look good in the future, and the switched on trader must respond.
Let’s look at the recent price history of BHP Billiton as an example of how anchoring can catch you out.
- Say a trader came into the market in September 2007 and eyed off BHP’s stock, deciding that whilst it was trading around $45 a share, due to the miracle in China it was worth closer to $60. They buy in certain of an easy profit.
- By Dec 2007, BHP’s stock plummeted to $35.
- A trader anchored to the concept that “BHP is worth about $60” would hold on in the stubborn hope that their initial analysis remains intact; that the right thing to do is simply to hold and wait until the market realises the value in BHP.
- After all, they tell themselves, BHP is a quality blue chip stock and it will definitely go back up. One only loses when one sells and therefore there’s no point selling at $35 when by simply waiting long enough, one will eventually be able to get $45 again.
- By the end of December BHP is in-an-almost-vertical descent as the first rumblings of the Credit Crisis surface. With the price now at $30 and the market in a panic, the investor realises their initial analysis was incorrect and chickens out.
- It’s the exact low and BHP rallies strongly to a high of $50 by May 2008!
- “See, I knew it! BHP was worth $60 a share…I’m such an idiot…I knew I should have hung on! Ahhh I always sell at the low!”
- The investor berates themselves for getting it wrong again.
- “Well, I’m not going to make that mistake again. BHP is now at $50, I know it’s going to $60, I’ve always known it was going to $60. If I buy twice as many shares now I’ll be able to make back my losses from last time when it definitely goes to $60 this time…”
- The investor piles in; this time buys twice as many BHP shares as their last bet. $50 is the exact high of BHP as the GFC obliterates any optimism over China and resources company shares tumble. By July 2008 BHP is trading at $40. The investor is staring down the barrel of another loss.
- “I’m such an idiot! I’ve done it again! I can’t believe it! I always buy at the top! I must be the unluckiest investor in the world…it’s not fair the market is out to get me!
- Well I’m not going to make the same mistake as last time. Last time I sold at the bottom when I should have just held on. If I just held on, BHP would have gone back up like it always does and I wouldn’t have had to take that loss.
- Surely this is the bottom now; I mean BHP can’t go below $40 because it’s way too cheap here. I’ll buy a few more at $40 so that it will only have to go back up to $45 for me to break even…I promise I’ll get out there and never trade BHP again…this is a mug’s game!”
- Three months later BHP is at $30 and the investor is losing over 4 times their initial loss from the first trade!
- “Ahhh…I knew I shouldn’t have bought any more at $40…that’s it, I don’t care what happens, I WILL NOT SELL until I break even. I AM NOT GOING TO LOSE AGAIN. I am the unluckiest investor in the world. It’s not fair!”
- A couple months later, the GFC is causing the most revered banks in the world to fail and is plunging the world’s biggest economies into recession. BHP has slumped to just $20. The investor can only see negativity in the press and their mind is boggling at prospect of a prolonged global depression. Their loss is staggering, but now they realise it could get a whole lot worse.
- “I just wanted to make back my first loss. I just wanted to make $10 on BHP. Now I’ve lost $40 per share on twice the amount!! It’s so unfair. BHP is the worst company in the world. I knew I should have gotten out at $30. I can’t believe this is happening again.
- “Well that’s it. I’m not playing this game anymore. BHP, nay, the whole market can go to hell! You’re not getting any more of my money. I’m getting out here and that’s it, I’m not even going to look at the market again. I’ve always said this is a mug’s game.”
- The investor finally admits defeat and sells at $20. This is the exact low price of BHP. The worst of the GFC storm passes, sanity returns to the markets and prices around the world bounce. Economies stabilise and recover, and within a year BHP is trading at $40 again.
Perhaps you can relate to the above story, or your own personal version of it. If you can’t then there’s a chance you just haven’t been in the market long enough yet! The best traders in the world have faced these exact scenarios, many times and have still gone on to make fortunes.
What makes them different from the average punter? Well, eventually, after making the mistake our punter did above, they learn it is far better to cop a small knock on the chin than to hang onto a losing investment and experience the death blow.
Traders who have a winning mindset do not fall prey to anchoring. They understand that the biggest threat to their profitability is taking big losses. The best way to ensure one takes a big loss to be completely inflexible to the possibility that one is wrong, and that the price may never get back to one’s break even point.
Even if it does, who is to say that one will have the intestinal fortitude to ride the storm from peak to trough and back to peak again? Further, how many other opportunities will one miss while they’re holding on to that burgeoning loss? Finally, what is the emotional and long-term psychological impact of holding a loser all the way down? It’s just not worth it.
The best traders, the winners, are ironically the best losers; those who can take a small loss in order to avoid it becoming a big loss. Losing investors can’t admit they’re wrong by taking a loss when it is still small. This ensures that they end up taking big losses and cements them as losing investors.
Traders need a proven process to counter negative emotions and behavioural biases; this will make it easier to swallow a loss, lead to better profits and avoid you being snagged with needless anchors.
Many investors make themselves feel better by telling themselves “It’s OK, I only lose when I sell. The market goes up in the long-run; I just need to hold on and eventually I’ll get back to break even. Why take a loss now when I can just hang in there a little longer and get my money back?”
This kind of thinking is dangerous to your capital..
Market anchoring costs investors a fortune in lost capital and lost opportunity. They hold on in the hope that their purchase price will be seen again and stubbornly believe their initial hypothesis about the stock is correct and will be proven to be correct. Whilst they are holding and watching their losses mount, they are also missing out on other trading opportunities which will inevitably come their way.
If this type of thinking sounds familiar to you, it may explain why you are yet to make substantial and consistent profits out of the market. It will also explain why you’re portfolio is littered with dog stocks which are trading at a fraction of their hey-day prices and are going sideways at best.
The reality is harsh, it’s unforgiving, and it’s as plain as the fleas on the dogs in your portfolio! You don’t lose when you sell; you lose the second the share price moves against your initial entry price! This is an inescapable reality of the markets, no matter how much some investors want to bury their head in the sand and pretend it’s not true.
The current price of the security, often known as the market price, is the purest concept in finance. It doesn’t matter what you think a stock is worth, despite your bemoaning the fact that the “market has gone mad!” It is the blatant reality of your current worth in a trade. Take it or leave it, the market price of any security is the best you will get right now. Don’t worry about what the price might be tomorrow or next week – anything can happen between now and then – for the good and for the worst!
Some stocks do recover of course, and some will even surpass their crash lows. In these cases, the investor pats themselves on the back for doing the right thing and hanging on. This becomes vindication for placing their undying faith in the stock in question: “See, clearly the right thing to do in a crisis is not to panic, not to sell out in a frenzy like all of those Nervous Nellies, but to hang in there and trust that eventually the market will come to its senses and realise the inherent value in my stock!”
Certainly, many stocks do come back, however far too many don’t, or don’t ever get close to their peak prices. Some of course, like Babcock and Brown, ABC Learning Centres, and Allco Finance Group disappear altogether. Do the punters still holding onto their CHESS statements for these stocks believe they only lose when they sell? They can’t sell!
I’ve got a theory for my money. I reckon that once you hear it you’ll want to adopt it for your money as well. Only the best will do. I don’t want to be stuck in dog stocks for years on end just waiting to break even. I want to be in the best trading opportunities the market has to offer at any one time. I want a steady stream of income and to see my wealth growing…and growing!
I don’t care where these gains come from or what the companies I trade in do – I just care about them going in the direction I’ve picked. If they don’t, I give them the boot quick-smart. After all, there are plenty of other stocks out there and I’m not married to my trades. I’ve never taken a romantic walk down the beach in the moonlight with BHP! I don’t love it!
Finally, and the most important thing: I don’t care about what my entry price was. It’s just a number. The market price is a far more important number for building my wealth. It’s the only thing standing between me and finding an even better trading opportunity to stick my hard earned cash on.