Course 508: Behavioral Pitfalls, Part 2
Pitfall: Anchoring
In this course
1 Introduction
2 Pitfall: Anchoring
3 Pitfall: Confirmation Bias
4 Pitfall: Mental Accounting

Ask New Yorkers to estimate the population of Chicago, and they'll anchor on the number they know--the population of the Big Apple--and adjust down, but not enough. Ask people in Milwaukee to guess the number of people in Chicago and they'll anchor on the number they know and go up, but not enough. When estimating the unknown, we cleave to what we know.

Investors often fall prey to anchoring. They get anchored on their own estimates of a company's earnings, or on last year's earnings. For investors, anchoring behavior manifests itself in placing undue emphasis on recent performance since this may be what instigated the investment decision in the first place.

When an investment is lagging, we may hold on to it because we cling to the price we paid for it, or its strong performance just before its decline, in an effort to "break even" or get back to what we paid for it. We may cling to subpar companies for years, rather than dumping them and getting on with our investment life. It's costly to hold on to losers, though, and we may miss out on putting those invested funds to better use.

Next: Pitfall: Confirmation Bias >>


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