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Many things can throw us off track as investors.

Some of those are external factors, like losing a job or facing a string of big bills hitting you at once.

Others are behavioural traps we fall into. The one I want to talk about today is called ‘anchoring’.

This is where we cling onto a single piece of information, which impacts our ability to make sensible investing decisions. In the share market, anchoring can manifest itself in many different ways.

It can trick us into trying to time the market, overlook good investments, and hang on to sub-par ones. So as you can imagine, it’s an important concept to understand!

Let’s look at the ways anchoring can occur, and what to watch out for.

“The market is overpriced”

This form of anchoring typically happens during a bull market, when shares have been going up for a few years. People look at the level of the market, compare it to where it was a few years ago, and decide it’s overpriced.

This is mostly just based on the fact that it’s higher than it was. Of course, the media’s daily stories about impending doom and inevitable collapses feed into this belief too.

But sometimes it’s more innocent. After we’ve bought shares, we’re reluctant to pay a higher price the next time we buy. This is because it increases our ‘average’ purchase price. But here’s where it goes off the rails: our ‘average’ price paid is arbitrary. It’s irrelevant what the price used to be. People do this with both ETFs and individual shares.

“I bought at $60 per share, but now it’s $80. I think I’ll wait until it gets back to the $60’s range, or at least under $70”. But who says it will? How do you know? We’re now playing the “timing the market” game with all the issues that entails, which I’ve written about before.

The truth is, we have no idea when it will drop to $60 again, or if it ever will. Yes, it could be overvalued right now. Or, just as equally, it could have been undervalued before. Alternatively, both prices could also be considered fair value based on all the available information at the time. All three are possible, and quite frankly, it’s a little arrogant to be supremely confident about which one it is.

Remember, the market generally goes up over time. This means we should expect to pay more for our shares as the months and years go by. It doesn’t mean shares are more ‘expensive’. If profits and dividends have also increased, shares may be just as reasonably priced as before.

It’s the same with property. If you were going to buy property over a 15-year period, would you expect the price you pay for each property to stay the same? Of course not. You’d generally accept that prices rise over time, as do rents. Which is one of the reasons we want to own assets like that in the first place.

As lifelong investors, we must be prepared to pay higher and higher prices for the assets we’re buying over the course of our lives. This is something people often forget.

“I’d never sell my shares in ‘XYZ’, my return is huge”

This one is far more common among older investors, who, through skill or luck, have managed to pick and hold onto a huge winner.

Let’s say an investor bought shares in CSL Limited back on the 30th of April 1999. They bought a $10,000 parcel of shares. During the following 12 months, the investor earned $277 in dividends, a 2.77% yield.

Fast forward to today, and that original parcel is worth $714,000. The annual dividends received, based on the last two dividend payments, now amount to $8,453. An incredible return in anyone’s book.

These yearly dividends represent 84% of the original purchase price. The investor thinks: “holy crap, I’m earning 84% in dividends each year… I’m never selling these shares!” But this thinking is faulty, and I’ll explain why.

Our investor no longer has $10,000 sitting in this investment to earn those dividends. Instead, they now have $714,000 tied up in these shares. So the dividend yield based on the current value is more like 1.2%.

Why is this the more accurate way to measure it? Because our investor can sell these shares at any time and put this money into a different investment. So, they need to be aware of any ‘opportunity cost’ of holding versus what returns they could achieve elsewhere.

Over time, looking at your ‘yield on cost’ may be interesting, and perhaps motivating. But it does not mean you’ll earn a higher annual return going forward than an investor who buys CSL today. That makes no sense. Which means, it should not drive your decision-making around whether to continue holding the shares or not.

Now, tax is obviously a serious consideration, and a different discussion. The point here is that the price paid for these shares 20-odd years ago (or whenever the investor bought) has no bearing on that stock’s return to you on a year to year basis right now.

Always look at how much money is tied up in a certain investment and what it could potentially earn elsewhere. Just to be clear, I’m not saying selling is the right move, nor making a judgement on the dividends or future returns. I’m merely pointing out the misleading nature of anchoring to the price paid many years ago to make investing decisions today.

“This investment has done poorly for the last 5-10 years. Why would I buy it?”

If you’ve spent any time on investing forums, you’ll have seen this type of discussion before. A lot of times (though not always), it’s newer investors who fall into this trap.

We look at a particular share, fund, or market, and check its performance to see if we think it stacks up as a ‘good investment’. This makes perfect sense on the surface. Who wants to buy a crappy investment?

But making a decision based on recent price performance (even 5+ years) can be equally misleading. The truth is, every asset goes through periods of sunshine and storms. By choosing an arbitrary start and end date in which to judge a market or fund, we can quite easily, and unknowingly, come to the wrong conclusion about that investment.

This also happens with investors who already own a certain fund or investment. After holding through a period of poor or negative returns, the investor might conclude that they should sell their shares. But again, this isn’t necessarily the case.

The US share market had no capital growth from 2000 to 2013. Aussie shares had no capital growth between 2007 to 2022. Even though both markets saw growth during those periods and monstrous gains before that start date, by measuring certain points in time, and looking only at price, many good investments will occasionally look terrible.

This means we can’t ‘anchor’ to past prices to decide what constitutes a good investment today. Because an investment or market which has just experienced a long stint of poor returns could outperform going forward.

In fact, when it comes to markets, this tends to be more likely than not. Over the long term, many things tend to even out - a concept known as ‘mean reversion’. This essentially states that asset classes will have strong and weak periods, but will gravitate towards a long term average over time.

The lesson: don’t look at prices from arbitrary points in the past to judge the quality of an investment today.

Final thoughts

Each of these are examples of how anchoring to past prices can lead us astray. This bias can cause us to make faulty assumptions about the right course of action to take with our investments.

Of course, there are times when markets are overvalued; poor investments should be sold; and a large possible tax bill means it can make more sense to hold than sell. But I hope this article helped you realise that while it’s useful to consider the history of an investment, we shouldn’t make that the only consideration.

More important than past prices. is looking at the fundamentals of what we’re investing in. This is something I discussed in the article: How do I research what to invest in?

Anchoring is an important concept to understand, but it’s not intuitive. So don’t be afraid to sit with this idea for a little while and ponder it some more.

Until next time, happy long term investing!

Dave