Buy a stock at $10, watch it drop to $3, and some people will decide to sell it only when it gets back up to $10. This can happen because people are desperate to avoid any loss, but also because they have no other information with which to determine what a stock is worth, so the brain will shoot from the hip to come up with a quick guess.
This could be a classical example of what psychologists call "anchoring," a type of cognitive bias that affects decision making. Anchoring, a reflexive judgement that is not informed by all the relevant facts, is usually followed by adjustments in which a response or decision is adjusted away from the anchor based after the consideration of more information.
To psychologists, this can be an example of anchoring, a type of cognitive bias that affects decision making. Anchoring is usually followed by adjustments in which an answer, value, or decision is adjusted away from the anchor based on deeper analysis or more information being considered.
In Jason Zweig's book, Your Money & Your Brain, an excellent demonstration is provided in which people are asked to quickly blurt out the response to the following question: "If John F. Kennedy had not been assassinated, how old would he be today?" Quick - don't think - just answer.
Now, take that first answer that appeared in your head and decide if you want to revise it after taking a moment to think about it. I've asked this of numerous people and the first answer is almost always in the 70s. The second answer, the revised answer, seems to usually fall into the 80s range. But since Kennedy was born on May 29, 1917, he would be celebrating his 95th birthday later this year.
Mr. Zweig explains that the initial answer is usually so off because we have an anchor in our heads about Kennedy. The image of a healthy fortysomething is burned into our memories because the footage of his assassination is one of the most recognizable events in modern history. You're probably picturing it right now.
Initially, our first response is anchored to that mental picture. The subsequent adjustment revises your initial gut reaction based on working through some simple math such as estimating how old he was in that picture and factoring in the time that had passed.
There might not be much adjustment in the case of the amateur investor who has not done any research or modelled a stock price he or she believes the company is worth. They don't really know what they're doing and in the absence of any other information, they can become anchored around an initial stock purchase price.
Whenever someone asks me if they should sell or hold on to a loser, my answer is usually the same: "If you have to ask, you probably shouldn't be picking stocks on your own." If you don't have a clear rationale for your investment decisions, your brain can fill in the gaps in interesting ways that may not be beneficial for long-term investing success.
Preet Banerjee, B.Sc, FMA, DMS, FCSI, is a W Network Money Expert, and blogs at wheredoesallmymoneygo.com. You can also follow him on twitter at @PreetBanerjee
Preet Banerjee