The Anchoring Effect
The importance of choosing your mental heuristics wisely
Bitcoin and other crypto-related assets have been declining over the first two weeks of 2022. The Wall Street Journal attributes bitcoin’s recent move to the overall decline in the stock market and negative investor sentiment regarding potential Federal Reserve policy actions later this year. However, analysts seem confident that bitcoin should have strong support at the $40,000 level:
On Tuesday, bitcoin rose 1.7% to $42,407. Most observers say the $40,000 level for bitcoin is a line in the sand for the bulls, and they expect a churning trade in this range. “The price action of bitcoin is still likely to remain volatile as a result of a hawkish Fed,” said AvaTrade analyst Naeem Aslam.
Why is $40,000 a critical level?
Perhaps that level is cited because it is a round number and because bitcoin has not traded below $40,000 in about six months. However, it is not as if the cryptocurrency hasn’t traded well below $40,000 in the recent past — it traded below that level for several months during 2021.
For whatever reason, $40,000 is a “line in the sand” for many observers who either plan to step in with buy orders at that level or expect other investors to do so. They have mentally anchored to $40,000 as a significant level for bitcoin.
Does this make any sense?
When looking at anything that seems irrational at first glance, we need to recognize that the world is an incredibly complex place and that it is not possible for most human beings to function without resorting to heuristics.
Modernity has brought enormous material benefits to society but has also increased complexity exponentially over the years. Perhaps even more importantly, our perception of complexity has dramatically increased due to constant exposure to information flowing at the rate of a fully open firehose.
It is impossible to deal with the complexity of the world without adopting heuristics, which are approaches to solving common problems based on short-cuts. If we attempt to solve every problem we encounter by resorting to first principles, the quality of our decision making might improve but the velocity of the world would guarantee that we will fall hopelessly behind when it comes to getting anything done. As a result, we consciously or subconsciously adopt heuristics that might not be perfect but are usually good enough for our purposes.
One of the most common heuristics people adopt is the practice of anchoring to a well-known and easily accessible reference point.
Anchoring is very evident in consumer behavior. When you arrive at a car dealership, the salesman wants you to anchor on the manufacturer’s suggested retail price of a car, not the true market value based on what customers are actually paying in negotiated transactions. Once you are anchored to the sticker price, the salesman can offer discounts that make the car seem like a great deal. In this scenario, technology has caused more and more customers to anchor on true market value because it can be easily found online. What was once hidden from view is now exposed for all but the laziest consumers to discover. This is great news for consumers but not a welcome development for car salesmen.
There are a number of different types of heuristics that I won’t go into (the Wikipedia article on the subject is actually quite good). My point in bringing up the subject is to recognize that heuristics and both essential and dangerous. In situations where the risk of being wrong is low, using heuristics can save a lot of time especially when you encounter the situation repeatedly. But we must be wary when it comes to using mental short-cuts for any decision that has significant consequences.
It is natural for the owner of any asset to wonder what it might be worth if it is sold. In the case of business ownership, a stark contrast exists between the mentality of an owner of a privately held business and the owner of shares of stock that are actively traded in financial markets.
If you own a small business, you probably have only a vague sense of what it is worth, and your perception of value is almost certain to be based on how much money you have been able to make over time. If you own a restaurant and experience a few slow weekends, you are not likely to mentally change your vague estimate of what it is worth. But if business is slow for a year and shows no sign of turning around, you will start to slowly update the number that you have in mind. The same is true when business is booming — you will only slowly adjust your assessment of business value.
But the situation is completely different with actively traded securities. The owner of a share of common stock knows precisely what his or her shares are worth at any moment in time when markets are open, down to the penny. The vast majority of owners of common stock or any other financial asset will constantly update their mental model of the value of their investment purely based on the quotation provided by financial markets.
Does this make any sense?
It is obvious that the intrinsic value of a business cannot possibly change on a minute-to-minute basis and that security prices fluctuate far more dramatically than the underlying value of a business.
Intellectually, most investors will acknowledge that this is the case and that it makes no sense whatsoever to anchor on quotations.
But the vast majority of them will anchor on stock prices anyway.
This is because anchoring is a powerful heuristic that is very useful in many contexts outside investing. Since heuristics are useful in general, they can easily be misapplied in situations where it makes no intellectual sense to do so. The fear of losing money and the thrill of making money are powerful forces to reckon with and with stock prices being so readily available, the mental short-cut of conflating price and value is taken by almost everyone.
In March 2020, stock prices plummeted as investors came to terms with the reality of the pandemic and the dire implications for business. In early March, I attempted to take a 30,000 foot view of the correction then underway to assess the actual impact of a temporary lock-down on business values.
The point isn’t that I was right about forecasting the future course of the pandemic (no one was) but to emphasize that even though we need to anchor on something, we have the ability to choose what it is we will anchor to.
I was not willing to use market quotes as an anchor point and determined to anchor on some logical assessment of business value. Coping with market meltdowns is impossible if you anchor to market quotes with no further context. This is almost always a recipe for panic selling, not rational behavior.
My largest investment at the time was (and remains) Berkshire Hathaway stock which was being pummeled by late March. I was getting poorer and poorer by the day based on market quotations, but was it necessary to anchor to quotes? Or was there a better way to measure the actual damage?
It is important to not bury your head in the sand when it comes to investing and it was clear toward late March that the world was not going back to normal anytime soon. Rather than anchoring on the quotation of Berkshire Hathaway, I attempted to examine how each of its major businesses would be impacted.
Did the intrinsic value of my stake in Berkshire Hathaway take a hit in early 2020 due to the pandemic?
Of course it did because the pandemic had a major impact on the business results of the company’s investees as well as its wholly owned subsidiaries. But I came away from the analysis comforted by my assessment that operating earnings were unlikely to be negative or consume cash for extended periods of time:
Despite the inability to be precise, it seems to me that it is highly unlikely for Berkshire’s operating earnings to be negative or operations, in aggregate, to consume cash for any length of time. If there are quarters in which there are operating losses for the group as a whole, Berkshire certainly has ample cash resources to avoid any kind of financial distress.
Like everyone else, I had to anchor to something during that period of great uncertainty. I did not have the option of just not thinking about it, nor did I have the option of pretending that nothing had changed.
The only recourse was to find something logical to anchor to.
Anchoring to daily quotations not only makes little sense logically but would be self-imposed mental tyranny and allow random fluctuations to dictate my state of mind. I had to find an alternative, so I did the research needed to write that article much more for my own sanity than for the benefit of my readers.
Since I started this article with bitcoin, I should come back to the subject of cryptocurrencies and how investors are anchoring to price.
Bitcoin owners are doing what investors in stocks have always done, so in that way their mental model of anchoring is nothing unusual. The difference is that, unlike a business, bitcoin has no underlying fundamentals that can be used to arrive at an estimate of intrinsic value outside of the immediate supply and demand dynamics setting today’s price.
To be more precise, bitcoin has no fundamentals that I can personally understand well enough to estimate a value independent of its quotation.
The risk of making a statement like this is that it might attract angry comments from cryptocurrency investors who insist that there are fundamentals at work that I am glossing over.
Fair enough. What are those fundamentals?
Bitcoin owners would likely state that the supply of bitcoin is capped at 21 million and that this amount can never be exceeded. If bitcoin continues to gain acceptance as “digital gold”, incremental demand as it goes mainstream will hit up against a firm supply limitation driving up the price. In contrast, the supply of nearly anything else can increase, including the number of shares outstanding of a popular common stock.
Bitcoin owners also often compare the market capitalization of bitcoin to gold and further note that, unlike bitcoin, gold’s future supply is not fixed. Gold is regularly mined, and a rising gold price is an inducement for more mines to produce more supply. If the price of gold gets high enough, people may even melt down jewelry further increasing supply. But no matter how high the price of bitcoin gets, there will never be more than 21 million coins in circulation in the future assuming the technology works as promised and cannot be hacked or otherwise compromised.
While these points might be valid, it is notable that the argument is still based on supply and demand dynamics, just taking a longer-term outlook. There is still no measure that is independent of supply and demand in the marketplace that we can use to estimate the intrinsic value of bitcoin. I can use the earnings and free cash flow of a business to estimate its intrinsic value. There is no parallel to earnings and cash flow for an asset like bitcoin.
While I have tried to understand these perspectives and to keep an open mind, I remain unconvinced regarding the value of bitcoin and other crypto assets that have no cash flow or other independent means of assessing intrinsic value.
But my lack of belief is only ancillary to the point I am trying to make:
In order to hold any asset, my mind demands that I anchor to something.
I need to form an opinion regarding the value of what I am buying and what I own. In the case of some businesses, I can develop an estimate of intrinsic value which will be updated over time based on criteria that is entirely independent of the stock price itself. I can anchor to that estimate rather than daily stock price fluctuations.
I have no such option when it comes to bitcoin or other cryptocurrencies. If I owned bitcoin, whether I like it or not, my mind would anchor to its daily price. If the stake was enough to be meaningful to my net worth, anchoring to the daily price of bitcoin would impact my daily state of mind. This is not my idea of a good way to live my life.
I am not excluding the possibility that other investors might own assets like bitcoin and be able to develop an investment thesis that allows their mind to anchor to an estimate of value that is independent of the price itself.
Bill Miller, who has fifty percent of his personal portfolio in bitcoin, is not someone who is blindly anchoring to its quotation. He must have some independent idea of the value of bitcoin that he is anchoring to. I am sure that he is not mentally tortured when bitcoin’s price fluctuates against him because he has formed an independent assessment of its value.
But it is not wise to outsource your thinking when it comes to investing if you are picking securities yourself, nor can you achieve personal conviction or staying power by coat-tailing another investor, regardless of who that investor is.
When it comes to investing, the world is full of assets to own, and it is important to be cognizant of your own capabilities and psychology. What I think is universal, however, is that almost all human beings will anchor to something when it comes to the value of what they own.
But we get to decide what to own and what metrics to anchor to.
If we are disciplined, adopt the right mindset, and only own assets where the fundamentals are personally well understood, we can then choose what we will anchor to rather than looking only at market quotations.
Anchoring on market quotations exclusively is a recipe for stress, misery, panic selling, and financial loss and therefore should be avoided at all costs. So, it seems logical that we should select investments where an anchor independent of market quotes is possible. This will vary for each investor based on their temperament, background, and analytical skills.
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