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Behavioral economics: The power of anchoring

The fact that the FTSE 100 index level is approaching 7,000 (rather than, say, 100, 999 or 10 million) reflects the decision of the index’s designers to set the initial value of the benchmark at 1,000 in 1984, when the FTSE 100 made its debut.

The change in the value of the index since shows the historical evolution of a portfolio including the largest UK-listed companies.

Yet it’s a human trait to become fixated on particular numbers. In a Financial Times article, investment columnist John Authers describes the recent success of fund manager Tom Howard. Howard refuses to record the buying price for any equity held in his portfolio.

By ignoring whether a sale of that equity might crystallise a gain or a loss, Howard argues that he is able to take a more dispassionate decision as to whether to keep or sell it.

Many of us, by contrast, are reluctant to sell out of losing positions as it would mean admitting we’ve got things wrong.

Identifying and describing the human psychological trait called anchoring helped economist Daniel Kahneman win the Nobel Prize in 2002.

In a classic experiment conducted in the mid-1970s with co-researcher Amos Tversky, Kahneman asked participants in a survey to look at a roulette wheel (numbered from 1 to 100) that was set to stop at 10 or 65. After watching the wheel spin, participants were asked to guess the percentage of United Nations countries that are African.

Those observing the roulette wheel stopping at 10 guessed a lower percentage for Africa’s representation at the UN (25% of countries) than those seeing the wheel stop at 65 (this group said that 45% of UN countries were African).

Even though there’s obviously no connection between the wheel and the UN, Kahneman and Tversky suggested that humans often use a numerical “anchor” as the basis of assessing probabilities, even when this leads to contradictory or inconsistent results.

Fund manager Tom Howard’s decision to try to ignore whether the positions he holds are trading at an unrealized gain or loss is therefore in some sense a recognition of the power of anchoring (and a way of trying to counter this powerful psychological trait).

The implications of behavioral economics (Kahneman’s and Tversky’s area of study) for finance and investment are still being explored. It’s fair to say that the economists’ ideas have gained increasing acceptance at the expense of classical economic theory, which assumes that individual actors are entirely rational.

For users of financial indexes, the insights of behavioral finance are well worth reminding ourselves of. Indexes actual levels, which we hear mentioned every day, are valuable pieces of information but we must be careful not to assign excessive significance to particular numbers. It’s important to understand indexes key use: as an objective representation over time of a particular market segment. And past performance is no guide to the future.

 

 

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