What is the Anchoring Effect?
The anchoring effect, demonstrated by Kahneman and Tversky, is the tendency for an initial number to disproportionately influence subsequent judgments. In investing, your purchase price becomes a powerful anchor. When a stock bought at $100 drops to $80, the thought 'I will sell when it gets back to $100' is pure anchoring. Whether the stock is worth buying or selling at $80 has nothing to do with what you paid for it.
Common Anchors in Investing
The 52-week high anchors investors into thinking current prices below that level represent bargains, even if fundamentals have deteriorated. IPO prices, analyst target prices, and all-time highs all serve as anchors that distort rational valuation. Round numbers ($100, $1,000) also create psychological anchors that influence trading behavior despite having no fundamental significance.
Overcoming Anchoring
Base investment decisions on intrinsic value metrics: P/E, P/B, dividend yield, and free cash flow yield. Ask yourself: if I discovered this stock today with no knowledge of its price history, would I buy it at the current price? Some investors deliberately hide cost basis information from their portfolio displays to prevent anchoring from influencing hold-or-sell decisions.