How did a relatively cost conscious guy like myself end up spending twice his original budget on a new vehicle? What strange magic led me from my quest for a basic model SUV with third row seating to an upgrade with leather and a heated steering wheel? Anchoring, that’s what.
Sure, the salesman deserves credit for escorting me up the spending ladder, but the real force at work was anchoring—that all too common cognitive bias in decision making where we rely on an initial piece of information to make subsequent judgments. Once the anchor is set we interpret all future information in relation to the anchor. The example of my recent car buying experience should serve as a cautionary tale for investors because sometimes, even when we know better, we find ourselves susceptible to this particular bias.
I had decided that I needed an SUV for Calgary living and I found some that started around $25,000 for a basic, no frills model. So this $25,000 price point became my anchor. If, as they say, you get what you pay for, the test drive of this model felt like I’d be paying for a cardboard seat pulled by two horses. Imagine my luck when there just happened to be a higher class model of the same vehicle with all-wheel drive, leather seats and more horse power available for “only” $30,000. That $5,000 hop represents step two of my anchoring journey. Once all fees and taxes were factored in, that $30,000 suddenly bumped up to $33,000 (step three). Well, if I was now paying $33,000, I better look around a bit more to see what other models are available at that price, right? I’ll fast forward through the rest of the steps, but you get the idea.
As I visited other dealerships, looking at SUVs from different makers in my revised budget range, I continued the process from where I’d left off. Eventually, after several more upgrades and incremental price bumps—each one perfectly rational in relation to the previous step—I ultimately became the owner of a $50,000 Ford Explorer that only slightly resembled the base model I set out to buy. I considered even “higher end” SUVs, and I could have easily continued up the price curve, but after I hiked up the mountain for a while, I looked back and saw just how far I had already climbed. Fortunately, that paused perspective stopped me from going any higher.
Increasingly in investment circles I’ve heard talk around price-to-earnings ratios to the effect of, “This slow grower is at 22X earnings already, so why not trade-up for the grower at 29X earnings? 7X is not that big of a difference for a potentially better result.” While I am not saying those judgments are necessarily wrong, I recognize the potential risk to investors anchoring themselves in the same way I did with my car purchase. Once you justify that first bump up it becomes easy to rationalize taking further incremental steps in that direction. Once the anchoring process begins it doesn’t take long to go all the way up to the “fully loaded” option, which could be detrimental to your portfolio.
In making a purchase decision it can certainly help to compare to something, and typically the market is a decent proxy. The problem is that anchors can move, which is exactly what anchors shouldn’t do. And when they move they can become somewhat arbitrary without us realizing it. Just as a fisherman doesn’t want a strong current to drag his anchor away from a targeted fishing spot, investors don’t want the momentum of anchoring to drag them off course either.
To guard against this, it’s important to step back and inject some good old fashioned common sense into the decision-making process. We can do this by comparing the multiples on both a relative and an absolute basis. Both perspectives provide important information. On a relative basis, for example, you might buy a 25X earnings company even if the market average is at 22X, justifying the 3X bump due to the company’s stable profile. But on an absolute basis, if you were to go back 10 years when the market for that stock was significantly cheaper, say at 16X, it might seem crazy to buy a company with those same characteristics at 25X today.
One way to maintain perspective and not climb too high or drift too far is to always look back at the base rate, which is essentially the long-term average. For example, buying a company at 25X may not be crazy compared to the current market at 22X, but if you discover that over the last 50 years the base rate average for the market is 16X, then 25X is probably too high. That’s information well worth considering. We’re not living in 1967 and history may not exactly repeat itself, but it often rhymes. Even though in a shorter time frame, on a micro level, it might make sense to buy at 25X, over a longer time frame does it still make sense in the context of our overall investment strategy? Are we still putting the odds in our clients’ favour?
The hardest part of the decision making process in investing is having the discipline to execute and follow a balanced approach. During the tech bubble, I think everyone understood that the market was very highly valued. However, most chose to ignore this and willingly continued to take “the next step.” It becomes all too easy to make justifications while disregarding traditional comparisons such as base rates thinking they no longer apply.
I’m happy to say that I don’t have buyer’s remorse. My new SUV meets all of my needs, in addition to providing some unexpected, yet welcome wants I didn’t even know I wanted going in. In retrospect, the whole episode reinforced the influence that anchoring can have on our decision making. I don’t share this story to warn against the perils of being upsold a better trim at the dealership; I share it because the same thing can happen in investing if you’re not aware of the bias. The biggest difference is that anchoring your investment decisions can be far more costly than any amount you’d ever pay for leather and a heated steering wheel.