Imagine I asked you to give me a range of values for which you are 80% confident you are right. For example, give me a range for your weight in which you are 80% confident. This one is easy. All you do is remember the last time you weighed yourself and maybe add or subtract 5-10 pounds. Success! You are an excellent estimator!
Where it gets hard is we live in a world which is increasingly more complex than guessing something as easy as our weight.
For example, give me a range for which you are 80% confident you are right for these values (answers are at the bottom of the page):
- Average weight of male orca whale (pounds)
- Distance from Omaha, Nebraska to Portland, Maine (miles)
- Deepest point in Lake Superior (feet)
- Number of people Blackbeard killed (humans)
- Length of Route 66 (miles)
On the surface, these are all relatively straightforward. However, chances are, you got more than one wrong. Why is this? It is because humans tend to fall victim to a cognitive bias called anchoring. What does this mean?
For example, when you thought of an 80% estimate for the weight of a male orca whale, what popped into your head? You probably recalled a time when you went to SeaWorld (back when it was socially acceptable) as a child. You remember sitting in the splash zone and seeing Shamu the whale. He was huge! HUGE. You remember a trainer somehow standing on him and getting him to do cool tricks. Maybe you even came home with a stuffed Shamu toy.
You probably anchored to this memory when thinking of an estimate for the whale. This is because humans tend to overweight information they know and have a hard time accounting for the things they do not know. Most 7-year olds cannot effectively judge the size of a whale and remember it 20 years later. However, we anchor to that memory and over or under-estimate many things. This same pattern likely held true with estimating the other four things (road trips, one time you visited Lake Erie, etc.).
Anchoring Bias in Investments
Why is the anchoring bias important for investors? Because oftentimes, we anchor without even knowing what we are doing. Predicting the future cash flows of a business or the success of a new business development is hard enough, but we make it harder for ourselves when we overweight irrelevant, outdated, or incorrect information.
For example, say you are looking for investment inspiration, Peter Lynch style. You look around at the things in your home. You look for things at the store you actively buy and know others buy. Hey, I use Gillette razors and my wife uses Venus razors. You do a little digging and see that Procter & Gamble owns both brands. Without any research, you conclude this is a great stock idea.
Where people fail is this is a starting point for research. After a little digging, you see that although P&G is a huge conglomerate, their grooming segment only accounts for 10% of their net sales and 16% of their net earnings. However, most investors will overweight the value of the information that P&G has a virtually monopoly on the razor market at grocery stores.
How to Prevent Anchoring Bias
It’s hard to be slow and deliberate in our fast-paced world. When making decisions, especially investment decisions, sleep on it. If a stock is undervalued today, it will be undervalued tomorrow.
Another trick is to ask yourself why? Why do I think X? Why do I think what I think about X? If you ask why several times, you can find the root of your thinking. If you think Company X is a great investment, why? Is it because a trusted source recommended it? Why did they recommend it? Why did they think it’s a good pick?
The last trick comes from Warren Buffett’s business partner, Charlie Munger. Invert. What does that mean? Instead of asking yourself why you are right, ask yourself why you are wrong. If you think P&G is great because they make Gillette razors, why are you wrong? This opens the doors to new information: board room fights, activist investors, declining market share, rise of gentrified razor providers, popularity of beards, etc.
Being slow and deliberate is never fun, but remember successful investors are those who make fewer mistakes over time than others. It’s not about being right, it’s about being wrong less often than others.
- 8,000-12,000 pounds
- 1,533.9 miles
- 1,332 feet
- 0 (there is no historical proof he killed anyone!)
- 2,451 miles