Pete Wargent blogspot
Co-founder & CEO of AllenWargent property advisory, offices in Brisbane (Riverside) & Sydney (Martin Place) - clients include hedge funds, resi funds, & private investors.
4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.
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Friday, 25 January 2013
Anchoring bias in investment
Anchoring is a cognitive bias which causes us to rely heavily upon the first piece of information we encounter when making decisions.
The first piece of information is known as “the anchor”.
Clever people with letters after their names have undertaken scores of tests to prove that this happens, although our understanding of exactly why it happens is less than clear.
An example: a group of people were asked to write the last two digits over their social security numbers. And then they were asked how much they would pay for a bottle of wine.
Those with higher digits on their social security cards indicated that they would pay more, on average, for the bottle of wine.
Similar tests continued to yield similar results.
The initial price offered for a car tends to have an unnatural bearing on the remainder of the negotiation, regardless of what the seller initially believed a fair market value for the car to be.
And so on…
Anchoring in share investment
The most common anchor in share investment is the price which investors buy a parcel of shares at.
Logically, once you own a parcel of shares intended for a long-term investment – tax issues aside – the price you paid for the shares should be irrelevant.
Instead, periodically the investor should consider the future prospects for the company and determine whether the shares held still represent good value by comparing to the market price last traded to the calculated value of the company.
Does this happen? Not often enough.
Instead, amateur investors become transfixed with the price which they paid for the shares.
If the share price has gone down since they bought in, they swear blind that they will not sell until the parcel of shares is showing an investment profit.
Unfortunately this is very often what catches amateur investors out. They allow the market value to fall and fall…and fall, until finally they can take it no more and sell out at the very bottom of the market.
By anchoring themselves to the price paid for the shares, they stopped looking at the investment rationally by asking “would I buy shares in this company today?” and instead say “I’ll sell when I’ve made my money back”.
They delude themselves that a loss is not real until it is crystalised and thus jeopardise their entire investment account through this one act.
Anchoring in property investment
Think back to the example of the car I referred to earlier. It’s very similar when it comes to property negotiations.
The first offer made for the property very often becomes the anchor for the remainder of the negotiation process.
I’ll give you an example of anchoring in property from my own personal experience.
Some years ago I was given mortgage approval for $500,000. I wanted to spend the full amount in order to maximise the value of property I bought.
I found a property in one of Sydney’s eastern suburbs – a beautiful apartment. It was originally listed for $540,000 but no buyer had been found and the price was dropped to $500,000.
Instinctively I wanted to buy immediately as it was in a cracking location and I offered the full $500,000 – panicked that someone else would jump in before me. The offer was accepted and I was delighted.
Looking back, I can see that it was obvious that I would pay the full $500,000. Why? Because I was anchored to two figures in particular. Firstly, I was anchored to the $540,000 which was the original asking price – I assumed by paying $40,000 I must be getting a bargain.
And secondly I was anchored to the figure of $500,000 because that it how much I wanted to pay.
Yet, in retrospect I think I could have negotiated the price down, if not to $490,000 then quite possibly to $492,500 or $495,000.
Happily for me due to a boom in the market, the property fairly quickly jumped in value by around 30% so I stopped worrying about it and went back to concerning myself with Sydney Roosters and their home form (which frankly was rather concerning).
In this instance I used a principal and interest mortgage which additional payments can be transferred against for no additional charge, so by paying down the mortgage over the years I have built a very handy pool of equity.
Lessons to learn
A few lessons can be learned from that experience:
Firstly, the asking price is irrelevant to the fair market value. The initial asking price was simply too high in this case.
Secondly, you should always try to negotiate the price of a property.
Thirdly, property is a tremendously forgiving asset class of mistakes over the long term.
And finally, we should try to remember not to panic as the bargain of a lifetime comes around about twice a week!