- Market Anchor it is a classic case of irrational behavior that can cost traders dearly.
- It describes our tendency to “get stuck” in a particular reference point to make judgments and decisions about actions.
- It serves as a lesson that most trader problems boil down to behavioral bias.
Anchors keep our minds on one place because they are a reminder of what was originally a good idea. For example, we may anchor a trade around our entry point of a stock because the price “looked good at the time.”
A common example of this is a trader who, after buying a stock whose price has dropped, a losing trade, sticks to his entry point as a signal to exit.
Acknowledging a loss is difficult, and many traders cling to their break-even point with hope. Come hell or high water they refuse to sell until they break even!
The risk is that while you’re waiting for a losing stock to break even, you may be waiting for something that doesn’t come and magnify your losses exponentially. This can be especially disastrous if you are leveraged on stocks through margin lending or CFDs.
Traders with a winning mindset can accept a trading loss, a virtue that separates them from underperforming traders. Successful traders avoid anchors by listening to the market, admitting that they have made an error in judgment, and enacting their trading plan.
Traders with a losing mindset stick to a desired exit point, neglecting their trading plan and the important mechanisms behind the market – demand and supply disappear, as the trader focuses on the anchor level.
Markets change and even the best traders will be wrong, in most cases quite often. What looked good in the past may not look good in the future, and the connected merchant must respond.
Let’s look at BHP Billiton’s recent price history as an example of how the anchor can catch you.
- Let’s say a trader entered the market in September 2007 and looked at BHP stock, deciding that although it was trading around $45 a share, due to the miracle in China it was worth close to $60. They buy with the certainty of an easy profit.
- By December 2007, BHP shares had plummeted to $35.
- A trader anchored in the concept that “BHP is worth about $60” would cling to in the stubborn hope that their initial analysis remains intact; that the right thing to do is just hang in there and wait until the market realizes the value in BHP.
- After all, they tell themselves, BHP is a quality blue chip stock and will definitely come back up. One only loses when selling and therefore there is no point in selling at $35 when by simply waiting long enough you will eventually be able to get $45 back.
- At the end of December, BHP is in an almost vertical decline as the first rumors of the credit crisis emerge. With the price now at $30 and the market in a panic, the investor realizes that his initial analysis was wrong and chickens out.
- It’s the exact low and BHP goes up sharply to a high of $50 in May 2008!
- “Look, I knew it! BHP was worth $60 a share…I’m such an idiot…I knew I should have stuck it out! Ahhh, I always sell low!”
- The investor berates himself for being wrong again.
- “Well, I’m not going to make that mistake again. BHP is now at $50, I know it’s going to $60, I always knew it was going to $60. If I buy twice as many shares now, I’ll be able to recoup my losses from the last time when it definitely hits $60 this time…”
- The investor joins; this time he buys twice as many BHP shares as his last bet. $50 is the exact high for BHP as the GFC erases any optimism about China and shares in the resource company fall. For July 2008, BHP is trading at $40. The investor is looking into the barrel for another loss.
- “What an idiot I am! I’ve done it again! I can’t believe it! I always buy at the top! I must be the unluckiest investor in the world…me!”
- Well, I’m not going to make the same mistake as last time. Last time I sold at the bottom when I should have held. If it had held, BHP would have gone back up like it always does and wouldn’t have had to take that loss.
- Surely this is the background now; I mean BHP can’t go below $40 because it’s too cheap here. I’ll buy a few more at $40 so I only have to go back to $45 to break even…I promise I’ll get out there and never change BHP again…this is a cup set!”
- Three months later, BHP is at $30 and the investor is losing over 4x their initial loss on the first trade!
- “Ahhh…I knew I shouldn’t have bought more at $40…that’s it, no matter what happens, I’M NOT SELL until I break even. I’M NOT LOSING AGAIN. I’m the biggest investor.” unfortunate man in the world. It’s not fair!”
- A couple of months later, the GFC is bankrupting the world’s most revered banks and plunging the world’s largest economies into recession. BHP has plunged to just $20. The investor can only see negativity in the press and his mind is boggled at the prospect of a prolonged global depression. The loss of him is staggering, but now they realize it could get much worse.
- “I just wanted to recoup my first loss. I only wanted to make $10 on BHP. Now I’ve lost $40 a share on twice that amount! It’s so unfair. BHP is the worst company in the world. I knew I should have gone for $30.
- “Well, that’s it. I’m not playing this game anymore. BHP, no, the whole market can go to hell! You won’t get any more of my money. I’m leaving here and that’s it, I’m not even going to look at the market again. I’ve always said this is a cup game.”
- The investor finally admits defeat and sells at $20. This is the exact low price from BHP. The worst of the GFC storm passes, sanity returns to the markets and prices bounce around the world. Economies stabilize and recover, and within a year BHP is trading at $40 again.
Maybe you can relate to the story above, or your own personal version. If you can’t, chances are you haven’t been in the market long enough yet. The best traders in the world have faced these exact scenarios many times and have still made fortunes.
What makes them different from the average bettor? Well, finally, after making the mistake our previous client did, they learn that it’s much better to take a little hit on the chin than to hang on to a losing investment and experience the death blow.
Traders who have a winning mindset are not victims of anchoring. They understand that the greatest threat to their profitability is suffering large losses. The best way to ensure that one suffers a large loss is to be completely unyielding on the possibility that one is wrong and that the price will never break even again.
Even if it does, who’s to say one will have the gut strength to ride the storm from peak to valley and back to peak again? Besides, how many other opportunities will one lose while holding on to that growing loss? Finally, what is the long-term emotional and psychological impact of holding on to a loser until the end? Not worth it.
The best traders, the winners, are ironically the best losers; those who can take a small loss to prevent it from becoming a big loss. Losing investors cannot admit they are wrong to take a loss when it is still small. This ensures that they end up suffering huge losses and cements them as losing investors.
Traders need a proven process to counteract negative emotions and behavioral biases; this will make it easier to swallow a loss, lead to better profits, and prevent you from getting hooked on unnecessary anchors.
Many investors make themselves feel better by saying to themselves, “Okay, I only lose when I sell. The market goes up long-term; I just need to hang on and eventually I’ll break even. Why take a loss now when I can hold on for a bit?” more and get my money back?”
This type of thinking is dangerous for your capital.
Market anchoring costs investors a fortune in lost capital and lost opportunity. They cling to the hope that their purchase price will be seen again and stubbornly believe that their initial assumption about the stock is correct and will be proven correct. As you hold and watch your losses mount, you are also missing out on other trading opportunities that will inevitably come your way.
If this kind of thinking sounds familiar to you, it may explain why you haven’t yet made substantial and consistent profits in the market. It will also explain why your portfolio is read with dog stocks trading at a fraction of their peak prices and going sideways at best.
Reality is harsh, unforgiving, and as clear as the fleas on the dogs in your purse! You don’t lose when you sell; you lose the second the share price moves against your initial entry price! This is an inescapable reality of the markets, as much as some investors want to bury their heads in the sand and pretend it isn’t.
The current price of the security, often known as the market price, is the purest concept in finance. It doesn’t matter what you think a stock is worth, even though you lament the fact that “the market has gone crazy!” It is the glaring reality of its current value in a trade. Take it or leave it, the market price of any security is the best you’ll get right now. Don’t worry about what the price will be tomorrow or next week; anything can happen between now and then, for better or worse!
Some stocks bounce back from course, and some will even break past their tumbling lows. In these cases, the investor pats themselves on the back for doing the right thing and sticking it out. This becomes a vindication for putting his undying faith in the actions in question: “Look, clearly the right thing to do in a crisis is not to panic, not to sell yourself into a frenzy like all those Nervous Nellies, but to hang in there. And I trust that eventually the market will come to its senses and realize the inherent value of my stock.”
Certainly, many stocks come back, however, too many do not, or never come close to their peak prices. Some, of course, like Babcock and Brown, ABC Learning Centers, and Allco Finance Group are disappearing altogether. Do punters still holding on to their CHESS statements for these stocks think they only lose when they sell? They can’t sell!
I have a theory for my money. I think once you hear it, you’ll want to adopt it for its money too. Only the best will do. I don’t want to be stuck in dog reserves for years waiting to break even. I want to be in the best trading opportunities the market has to offer at any time. I want a steady stream of income and watch my wealth grow…and grow!
I don’t care where these profits come from or what the companies I do business with do, I just care that they go in the direction I have chosen. If they don’t, I kick them quick and smart. After all, there are plenty of other stocks out there and I am not married to my trades. I have never taken a romantic walk on the beach in the moonlight with BHP! I do not love it!
Finally, and most importantly: I don’t care what my ticket price was. It’s just a number. The market price is a much more important number to build my wealth. It’s the only thing standing between me and finding an even better business opportunity to put my hard-earned money into.