New on FinoLib · Volume III: Finance Encyclopedia
I have just published a new article on FinoLib, my free finance education library: Anchoring Bias and Overconfidence in Investing Explained. It is part of Volume III: Finance Encyclopedia. Below is a summary of the topic in plain, expert language, so you can follow the idea even before you open the full article.
6.3 Anchoring
The idea in plain words
Anchoring means leaning too heavily on the first number you see when you make a later estimate. It is like a price tag that sticks in your mind. In investing, the costliest anchor is your own purchase price, which has no bearing on a stock’s future return.
Key points
■In Tversky and Kahneman’s 1974 experiment, a random wheel number of 10 or 65 moved median estimates from 25 to 45, even with payment for accuracy.
■Nearness to the 52-week high explains a large portion of momentum profits (George and Hwang, 2004).
■A 50% loss needs a 100% gain to recover, about 9 years at 8% a year.
A closer look
Anchoring is the tendency to rely too heavily on an initial number (the “anchor”) when making a later estimate, even when that number is irrelevant to the question. Tversky and Kahneman’s 1974 demonstration in Science is the classic: subjects watched a wheel of fortune produce a number between 0 and 100, said whether the answer was higher or lower, and then estimated quantities such as the percentage of African countries in the United Nations. The median estimate was 25 for the group that saw 10 and 45 for the group that saw 65, and paying subjects for accuracy did not reduce the effect. Tversky and Kahneman’s explanation is insufficient adjustment: people start from the anchor and move toward the answer, but stop too soon.
Decision rule
Apply a “fresh cash” test to every holding at least once a year: if this position’s current value were cash today, would you buy this security at today’s price? If yes, hold; if no, sell or trim, whatever you paid. The one exception is timing for tax: if a gain will turn long-term within a few weeks, waiting can be worth it (Part 6.7: The Disposition Effect).
The costliest mistake
Waiting to break even on a stock you would not buy today. A position down 50% needs a 100% gain to recover, about 9 years at 8% a year. Suppose, illustratively, the business has deteriorated and the stock’s own expected return is only 3% a year. Leaving $30,000 in it for 9 years grows to $30,000 × 1.03^9 ≈ $39,143; moving it into a diversified fund expected to earn 8% grows to $30,000 × 1.08^9 ≈ $59,970.
6.4 Overconfidence and Illusion of Control
The idea in plain words
Overconfidence is thinking your knowledge and forecasts are more accurate than they are. In markets it shows up mainly as trading too much. The cost is large and has been measured: in Barber and Odean’s data, the most active US households lagged the market by 6.5 points a year.
Key points
■US CFOs’ 80% forecast ranges contained the realized market return only 36% of the time.
■Men traded 45% more than women, and trading cut their net returns by 2.65 points a year against 1.72.
■In Taiwan, individuals’ aggregate portfolio lost 3.8 points a year to trading, equal to 2.2% of GDP.
A worked example
Worked Example — What a 2.65-Point Trading Drag Costs Over 20 Years
Assume, illustratively, a $100,000 portfolio and a 7% annual return before trading costs. Buy and hold: $100,000 × 1.07^20 ≈ $386,968. With the 2.65-point drag measured for men: $100,000 × 1.0435^20 ≈ $234,341. With the 1.72-point drag measured for women: $100,000 × 1.0528^20 ≈ $279,845. The higher-turnover investor ends about $152,600 behind the buy-and-hold investor, 39% of the passive outcome, with the same assets and the same gross return.
Decision rule
Set a turnover budget and make each discretionary trade justify itself. Before trading, write down the expected gain, why the counterparty is wrong, and the all-in cost (spread, commission, tax). If you cannot name the counterparty’s mistake, or the expected gain is not several times the cost, do not trade. As a rough guide, annual turnover above about 50% in a personal long-term portfolio deserves a written justification. Ignore the budget for rebalancing to target weights and for tax-loss harvesting, which are rule-driven, not forecast-driven.
The costliest mistake
Trading on conviction instead of measured edge. The cost compounds out of sight: the example above turns a 2.65-point annual drag into a $152,600 shortfall on $100,000 over 20 years, and nothing on a monthly statement shows the portfolio you would have had. Keep a log of every discretionary trade and compare it once a year with simply having held. If the log shows no edge after costs, it has paid for itself.
What the full article covers
In the full article I take you through these sections:
■6.3 Anchoring
■6.4 Overconfidence and Illusion of Control
It includes worked examples, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume III: Finance Encyclopedia
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The complete article, Anchoring Bias and Overconfidence in Investing Explained, with every worked example, diagram, quiz and source, is free to read in Volume III, Finance Encyclopedia on finolib.com.
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