It's pretty much one of the worst feelings in the world for an investor. Jim has done his research, narrowed down the field of potential "buys," and finally picked the stock that he likes.
Unfortunately, while Jim was busy debating, the stock shot up from $50 to $100 per share. Frustrated, Jim decided to look elsewhere to invest his money, convinced that he "missed the boat."
As I've said with many of the investing biases I've been investigating, the reasoning here is easy to understand, but this line of thinking can be very dangerous to Jim's portfolio.
The name for what we're covering today is anchoring. Read on to see what anchoring is, why it can hurt investors, and what you can do to mitigate the consequences of this bias.
Anchoring in the real world In the most simplistic terms, anchoring refers to the fact that the values of many things in life are relatively arbitrary. As humans -- and especially as Western thinkers -- we don't like this kind of uncertainty. So we develop a tendency to rely far too heavily on the first value, the "anchor," that is given to something.
Imagine if I ask one group of people: How tall is the world's tallest building? Do you think it's over 10,000 feet?
Then I ask a second group: How tall is the world's tallest building? Do you think it's over 5,000 feet?
When similar questions have been asked to participants in studies, those in the first group guessed a height significantly higher than those in the second group. The only difference was that each group was given a different anchor.
Anchoring in the investment world The same thing can happen on the stock market, as it did with our unfortunate investor Jim.
When a company is firing on all cylinders, the price of its stock is likely to go up. We anchor to the original price we saw the first time and assume that there's no room for growth left once the stock appreciates in value.
Imagine if you didn't buy Amazon.com, Inc. (NASDAQ:AMZN) at a split-adjusted $10 because it had been $3.50 just three months earlier, as was the case in late 1998. Sure, you missed some gains, but you'd still be sitting on a 27,300% return right now. Missing out on returns like that is why the anchoring effect is so dangerous.
Here are three stocks that have appreciated a great deal since Labor Day. But if you assume they're not worth your money now, I think you'll be committing the sin of anchoring to past prices.