Wednesday, April 1, 2015

Common anchors and how to get rid of them

Anchoring is defined as the common human tendency to rely too heavily on the first piece of information provided to make subsequent decisions. Dangerous market anchors in the world of portfolio management are (but not limited to):
  • Index P/E – relatively valuing companies to the index P/E is very dangerous
  • Price relative to the all time high – if a stock was trading at 50% over its fair valuation and is now trading at 25% over its fair valuation, it does not imply that one should buy it just because it’s down by 15%
  • Trading close to the all time or 5 year or one year low – Just because something is at an all time low or close to it does not mean it’s cheap. There could be something really bad going on with the company
  • Buying on days when the stock is down and selling when it’s up – again these are path dependent results and do not add to your returns. If it did many people would chase this arbitrage, some might even write computer programs to do this, and it would no longer be true. If you don’t believe me you can back test this to realize that the return generated from doing this is pretty much the cost of trading.

The way I have found to get rid of my biases is to have a simple list of companies with growth, expected return on capital, fair value and current value. This removes my relative bias and lets me look at the totality of the trade.

Some portfolio manager might ask that this is contrary to what I have been preaching about macro factors. Macro factors are just a general direction in which you can look to understand whether a gross mistake is being made, but as stated earlier they can form a very small part of the decision making. Typically their only use is to instil the right amount of fear in you before trading.

How does the intelligent investor know it’s an anchor? Sit back, relax, and think through it with the assumption that markets are NOT efficient. If it makes rational sense to you then it’s not an anchor else it is.

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