Most people display a stubborn streak at times, but in trading, refusing to budge from a position is known as an anchoring bias. This is when traders fixate on one main piece of information (the anchor) to make a decision even when at times it can mean fighting against the market.
Anchoring occurs in many day-to-day situations with one of the best examples being Black Friday. Marketing information tells consumers how much something should cost and then offers a deep discount. Much of the value that customers perceive is based on little more than anchoring.
Several ground-breaking studies by Kahneman and Tversky in the 1970s explained the effect of anchoring. They were interested in how people formed judgements when they were unsure of the facts. They found that when people are uncertain about the correct answer, they take a guess using the most recent number they’ve heard as a starting point.
Various studies have shown that even when people are told that the data they’ve previously heard is wrong or irrelevant it is still incredibly difficult to avoid factoring it into decisions.
Anchoring bias in trading
Traders exhibiting this bias are often influenced by their initial opinions, the initial trend, a stock on which they have made a profit in a previous trade or arbitrary price levels such as their entry or target prices. They are prone to clinging to these numbers when making their investment decisions.
It is, therefore, important to strike a balance: you must use past information for supportive research, but you must also react to the moving market. Giving too much weight to the first piece of information offered can lead to serious miscalculations if not risk-managed properly.
Anchoring also means that traders might discount underlying fundamentals about a stock price or fail to act when a trend is reversed. This reluctance to change their position means they can ride price falls to the bottom and suffer massive losses as a result.
One way to take this psychological bias out of trading is by adopting a stop loss strategy. Using a stop loss means you automatically close a losing position that you might have otherwise let run.
Stop loss management
A stop loss order attempts to prevent traders from hanging on to losing trades by being anchored to an original buy price. It is a protective mechanism that flags up when a trader should take the hit on a small loss before the price drops any further.
Analysts are torn on the merits of stop loss orders. On one hand, they provide a safety net to exit a trade once its movement begins to lose money. Yet, deciding where to set the stop order can be a tricky concept and it relies on a trader’s ability to assess how and when that limit might be triggered.
Some traders will also increase the stop-loss or cancel it when the price approaches the level set, hoping to allow the market to return to the opening level. Yet this is just another form of anchoring and should be avoided. It is important to learn how to calculate a stop loss accurately, and then stick to it.
The percentage method
The percentage method for setting stop losses is popular because it is simple. This is done by determining the percentage of the stock price a trader is willing to give up before they exit the trade.
Setting it at 10% of its value means that if the stock is trading at £50 per share, the stop loss would be set at £45 - £5 below the current market price of the stock.
The danger with using percentage stops, however, is that if there is heightened volatility in a market, the limit might be unexpectedly triggered outside of what might be considered normal market behaviour. A stop-loss order can only work with complete precision if there is an orderly market, yet this doesn’t exist.
Dan Dzombak, an analyst at the Motley Fool, is not a fan of stop loss strategies. He says that a trader should sell a stock if their initial investment thesis proves incorrect, but if the stock drops and the thesis still holds true then they should be buying at the lower valuation, rather than selling.
He adds: “In our world of fast-spreading misinformation and flash crashes, you don't want to be forced out of a stock that temporarily drops if you had planned on holding it for the long term. In the case of a flash crash, if you bought the stock back, it would be akin to buying high, selling low, and then buying high again. You would also have to pay taxes on any gains from your forced sale, rather than continuing to defer taxes by simply holding the shares.”
He uses as an example the Apple flash crash in 2014. “The stock had been trading around $119 per share. In a matter of minutes, the stock plunged to $112 before recovering to $115. If you had stop losses set at $113, your broker would have sold the shares somewhere below that level, just before the share price immediately recovered to $115. You'd have to buy back in at a higher price, and you'd owe taxes.”
Types of stops
There are three main types of stop that can be considered:
- Basic stops that will close out a position when a certain price is reached. These can be affected by slippage if the market moves beyond your specified price before your market maker can close your position
- Guaranteed stops work like basic stops, but can’t suffer slippage: There’s a small premium to pay for this but the guaranteed stop will always close the position at the price specified.
- Trailing stops follow the market if it moves in a trader’s favour – staying the same gap behind the moving price, so long as the price is moving in your favour. If the market turns, your position will close out at the trailing stop’s new level. This can help lock in profits.
Learning to lose
One of the golden rules in trading is that to become a professional winner, a trader has to first become a professional loser. Changing perception of loss is important when overcoming any behavioural bias including anchoring.
Nial Fuller, a professional trader, author and coach, says one of the biggest reasons most traders lose money in the markets is because they do not know how to take a loss. He says: “Instead of just taking a loss, they try to do all kinds of crazy things like moving their stop loss further from their entry point, entering multiple positions as the market moves against their initial position and other silly-emotional trading mistakes.”
Traders need to learn to take losses. The trick is to make sure the losses are always smaller than the gains made in successful trades. Overall, that is the route to profit. If an anchor bias – a focus on the first price – stops you accepting a small loss, it can lead to you making a larger loss. That could scupper your long-term trading performance.
How to prevent an anchor bias?
Traders can counter an anchoring bias by identifying the factors behind the anchor and recognising that most decisions are emotionally driven.
Successful investors don't just base their decisions on one piece of data instead they cross reference and get other people’s opinions. They also learn through experience and keep a record of their losses and wins so that they can identify performance mistakes.
At times it might be better to ignore the price level altogether and be consistent with making regular investments and be disciplined when holding an investment for a planned timeframe.
In essence, the key to overcoming this bias is to be flexible and objective, being able to evaluate prices and make decisions objectively whatever your current position.