The Dow Jones Industrials index has broken through 17,000 points for the first time while the S&P 500 is close to 2000. In the UK, the FTSE 100 is closing in on 7000. Do these round numbers matter? They shouldn’t but thanks to one of investment’s most dangerous behavioural biases they probably will.

The FTSE 100 has been here before. It came within a whisker of hitting 7000 at the height of the dot.com bubble in 1999 and retreated. It almost got there again before the financial crisis struck in 2007 but stopped a few points short. The recent market strength has seen a renewed assault. One of the reasons the market has tried and failed to break through this price ceiling is our tendency to latch onto completely irrelevant numbers and attach spurious importance to them. Behavioural psychologists call this bias “anchoring”. In a face-off with cold logic it invariably wins.

Anchoring is why market traders like to barter. On a recent trip to Dubai I bought some spices in the souk and without a doubt paid too much. By pitching his initial price high enough, the shopkeeper allowed me to feel good about beating him down while ensuring that he still made a fat profit.

The classic experiment to illustrate this cognitive lapse was conducted by the giants of behavioural finance, Daniel Kahneman and Amos Tversky. In this experiment, two groups of students were asked to estimate what percentage of the UN was made up of African countries. Before they answered, a rigged wheel of fortune was spun which showed one group the number 10 and the other group 65. The students were asked to think about whether the number they saw was higher or lower than their estimate.

The experiment showed very clearly the power of anchoring. The average estimate of groups that saw the number 10 was 25 per cent. Those that saw 65 answered 45% on average. They gravitated towards these numbers even though they knew that they were of no relevance whatsoever to the question they were being asked to answer. The right answer, by the way, was under 20 per cent.

Investing is full of similar instances. Anchoring is one reason why investors typically hang onto a losing position even when they know that circumstances have changed and the investment is no longer worth what it was. By fixating on a recent higher price, we convince ourselves that, at the new lower price, the investment must be good value. It may be, of course, but it is equally possible that we are in denial.

Today, we face the opposite risk – that we are intimidated by the market’s push into virgin territory and assume wrongly that a new high equates to overvaluation. The fact that 7000 marked the high water mark in 1999 is of no consequence in 2014 because the fundamentals on which the market’s valuation should be based are different. The world has moved on.

A look at history shows how little breaking through a round number can tell us about the future direction of the market. The FTSE 100, which launched in 1984 at 1000, smashed through 2000 in 1987 in the run up to that year’s market crash. Counter-intuitively, it was right to worry about valuations after the market had doubled but wrong to do so in 1993 after the market had trebled to 3000. Stepping back from the market then would have been an expensive mistake as it more than doubled again in the following six years.

The best way to avoid the pitfalls of anchoring is to try and forget where the market or an individual share has been in the past and focus instead on a tangible valuation measure that’s hard to fudge – the dividend yield. That’s because, at its most basic, when you invest in a share you are buying the right to enjoy the cash that a company will subsequently pay out to its owners, in other words its dividends.

Major indices these days are offering healthy dividend yields that compare favourably with bond yields, which offer no prospect of that income rising as a company dividends most likely will. Those are numbers worth anchoring onto.

Tom Stevenson
July 11, 2014
Source:  Professional Planner    www.professionalplanner.com.au