I’m about a quarter of the way through Daniel Kahneman’s new book Thinking, Fast and Slow, which I highly recommend to anyone interested in getting a better understanding of how our minds work when making decisions.
Beginning in the early 1970s, Kahneman, a professor at Princeton, along with his collaborator Amos Tversky, questioned the classical economics concept of humans as rational decision makers. Instead, they argued that people often make decisions using a system of biases and heuristics (mental tricks or shortcuts) that often result in irrational outcomes. Their findings and theories form the basis of the emerging field of behavioral economics, and their work was so noteworthy that Kahneman was awarded the Nobel Prize for Economics in 2002.
One section that struck me was the description of the anchoring bias. In a nutshell, anchoring describes our tendency to rely too much on one piece of information when making a decision. Once we’ve settled on our anchor, we adjust other pieces of information to fit that anchor in assessing probabilities.
As I read about this bias, I was immediately reminded of a prospect we saw about two years ago. He and his wife had sold just about all of their stock holdings when the Dow Jones Industrial Average hit 10,000 in October, 2009, thinking that the recovery had run its course. They believed that the market would soon crater, and that we wouldn’t see the 10,000 mark again anytime soon.
At Woodward Financial Advisors, our investment philosophy is grounded in the principles of broadly diversified portfolios and the avoidance of trying to time the market. Clearly, this put us at odds with this prospect couple.
Beyond that, this couple had anchored on Dow 10,000 as the baseline for their investment decisions…but why? Psychologically, 10,000 is a nice, easy round number. But rationally, there is nothing special about 10,000 for the value of the Dow.
We didn’t hear from the couple after our initial meeting. The Dow did in fact sink below the 10,000 level in the spring of 2010, “bottoming” out at around 9774. Given their strong convictions about the road ahead, I doubt that was the price level this couple was looking for in terms of getting back into the market.
This past Friday, the Dow closed at 12,019, which represents an increase of almost 20% since our meeting.
By making their investment decision based on this price level rather than value, the couple had anchored their decision-making process on one less-than-ideal piece of information. Assuming they’ve kept their money in cash and short-term bonds, taxes and inflation have eaten away at the nominal return they’ve experienced, resulting in a net negative real return.
The Dow 10,000 anchor could end up being a significant drag on this couple’s chances of achieving their long-term financial goals.