You hear it all the time. ''I bought in at $2. Once the share price gets back there, I'll sell.''
The idea of not selling the poor performers in your portfolio, at least until they return to the price at which you bought in, is common and often costly.
Psychologists call it ''anchoring''. If you want to avoid the mistakes it can produce - in ourselves and in those whose advice we follow - it pays to understand this concept.
Studies have shown how unrelated ''anchors'' influence people's responses to questions. In 1995 psychologists Karen Jacowitz and Daniel Kahneman (who later won the Nobel prize in Economics for ''having integrated insights from psychological research into economic science'') conducted a two-stage experiment.
Subjects were first asked to consider whether Mount Everest was taller or shorter than a given figure. After that, they were asked to estimate the height of the mountain. What Jacowitz and Kahneman found was quite fascinating.
Subjects who were first asked whether Everest was taller or shorter than 2,000 feet provided an average absolute estimate of 8,000 feet. Meanwhile, subjects who were first asked whether Everest was taller or shorter than 45,000 feet provided an average absolute estimate of 42,500 feet.
In other words, the subjects ''anchored'' their response to the second question (''How high do you think Everest is?'') to the way the first question was framed (''Do you think Everest is taller or shorter than ... feet?''), even though care was taken to explain that the initial ''anchor'' figure was generated randomly.
As I explained last week, this seems to be the way much analysis is conducted in financial markets; analysts ''anchor'' their valuations and price targets to the current share price, even though they know these prices often have little to do with underlying value.
Eye on the stock ticker
Ben Graham (author of our company's namesake, The Intelligent Investor) summed it up in a lecture to the New York Institute of Finance in 1946: ''Analysts have recently been acting in Wall Street pretty much as they always have, that is to say, with one eye on the balance sheet and income account, and the other eye on the stock ticker.''(For a detailed transcript of the lecture, see The Rediscovered Benjamin Graham by Janet Lowe).
Not much has changed over the past 60 years. And isn't just analysts that fall for this psychological trap. We all do.
Last week, in the aftermath of its latest result, The Intelligent Investor published a short piece of research on Telstra. After a 39-page report in October, titled Telstra on the Stand, we were, in the words of Peter Lynch in One Up on Wall Street, ''simply rechecking the story''.
Our research concluded that the decline in profitability from the company's traditional fixed line (or ''PSTN'') business would not be totally offset by profits from the growing mobiles business for many, many years. The evidence had been building for some time. Now it seems conclusive.
I've no doubt many Telstra investors, having bought in during the government privatisations at higher prices, will have ''anchored'' their expectations at this price. They might read our research - they may even agree with it - but taking action will be hard.
Holding on to poorly performing stocks until the price gets back to where one purchased is tempting because it means we don't have to admit our mistakes. Unfortunately, the chances are that by the time Telstra's share price ever returns to the level at which many people purchased it, inflation will have meant far less purchasing power for the original amount paid.
Anchor victim
How do I know so much about anchoring?
I'm familiar with its costly effects because I've fallen victim to it myself. Miller's Retail, now known as Specialty Fashion, is but one example. Brazin (the formerly listed owner of Sanity Music and Bras N Things) is another. Telstra, I'd suggest, won't be an addition to that list.
The key to not making anchoring mistakes is to first understand the concept and look for instances where it might be at work. No one, after all, can deceive us better than ourselves. Then, as do all good value investors, we must separate a stock's underlying, or intrinsic, value from its current share price.
Exploiting the difference between the two is the essence of our favourite activity; buying dollar coins for 50 cents.
And, for the record, Mount Everest is 29,029 feet high.
This article contains general investment advice only (under AFSL 282288).
Greg Hoffman is research director of The Intelligent Investor which provides independent advice to sharemarket investors. BusinessDay readers can enjoy a free trial offer at The Intelligent Investor website.
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