Excerpted from Fundoo Professor:
Similarly, a saving of Rs. 1,000 looks much bigger than it really is when it is contrasted with a purchase price of Rs 5,000 for a lamp, (a 20 percent saving!) but looks much smaller than it really is when it is contrasted with a purchase price of Rs 500,000 for a car (only 0.2 percent saving).
It does not matter to a man that a Rs 1,000 saving will have the same effect on his net worth whether he saves it on a lamp or a car. Somehow the presence of a 20 percent reduction triggers an irrational response in his brain.
The brain, operating at the subconscious level, is often influenced by the presence of false “anchors”. Anchors are pieces of information to which a mind tends to latch on to while making a decision. And the human mind will often latch on to false anchors created by various influences like availability or contrast.
In a classic experiment, researchers asked a group of people if the Mississippi River in the US is longer or shorter than 500 miles (the anchor). Most people responded that it was longer than 500 miles. They were then asked to estimate the length of that river. The average answer was about 1,000 miles.
A second group, in contrast, was asked if the Mississippi River is longer or shorter than 5,000 miles and were then asked to estimate its length. Most people responded that it was shorter than 5,000 miles but the average length of the River in this group was about 2,000 miles!
The actual length of the Mississippi River is 2,348 miles but false anchors of 500 miles or 5,000 miles tend to pull the average answers towards them!
In the lamp vs. car experiment, students who chose to walk ten minutes to save Rs 1,000 while buying a lamp but who refused to walk ten minutes to save the same amount of money while buying a car, were suffering from “anchoring bias”. Their minds were latching on to the wrong anchor of a large percentage savings on a list price, instead of latching on to the right anchor of their personal net worth.
Anchors are important, of course, but one has to be careful when deciding if an anchor is valid or not. A man who feels miserable because he dropped Rs. 500 from his pocket which had only Rs. 1,000 in it even though his personal net worth is Rs. fifty lacs is suffering from an anchoring bias. He incorrectly identifies the money in his pocket as a valid anchor as opposed to his net worth. He is also suffering from bias arising out of contrast effect because Rs 500 lost out of Rs 1,000 in his pocket looks very big to him in percentage terms.
In contrast, a rational investor who practices wide diversification, knows that its inevitable that some of his picks will turn out to be duds. He does, not, however, let such outcomes make him miserable because he has trained himself to latch on to the right anchors such as the size of his portfolio, and not the percentage lost in a single position.
A stock may have fallen 50 percent from its all-time peak in a market crash, may have gone below its 52-week low price, may have fallen below the price at which its shares were offered in a hot IPO, or may have fallen below par value. None of these things mean that the stock is cheap. A stock is cheap only if its price has fallen well below than what the company is rationally worth on a per-share basis.
In contrast with underlying value which is the right anchor to latch on to, all time peak prices, 52-week low price, IPO price, and par value are all false anchors. If you blindly buy stocks merely because they have fallen well below some false anchors, thereby allowing contrast effect to make you feel that they are much cheaper than they really might be, then you are functionally equivalent to the man who is trying to catch a falling knife.
