It is common to find ourselves relying on only one specific item of information when making a decision. In such cases, the information is called an ANCHOR. The tendency to rely too much on an anchor, and thereby make an irrational decision, is a cognitive bias we call ANCHORING.
For example, let's say that a month ago you were thinking of buying a particular stock that was selling for $150/share. However, you decided to wait. Since then, the stock has declined to $100/share. If you use the previous price of $150 as a reference point (an anchor), the current price looks like a bargain. However, if you depend only on a price comparison, you are neglecting to answer the real question: If you buy the stock at $100/share, is it likely to be a profitable investment?
The moment we buy a stock, the price becomes an important number. After all, what we paid will ultimately determine how much money we will make or lose on the investment. However, if we let the purchase price become an anchor, it will influence our decision making, and predispose us to the disposition effect we discussed earlier: the tendency to wait too long to take losses and to move too quickly to realize gains.
Anchoring leads to distorted thinking because our emotions and our intuition make it easy to use the anchor as a reference point. Instead, we would be better off making a more logical analysis, independent of previous costs or gains.
No one can guess perfectly and, over time, every investor learns that not all of his investments are going to make money. From time to time, it is important to be able to recognize a loss, close out the investment, and move on. If you can make more money selling a stock than keeping it, you should sell it, regardless of how much money you paid for it. There is no reason to consider what you paid for something, when you are trying to decide whether or not to keep it. Let me embody this guideline in the form of a rule:
— Harley's Rule of Investing #7 —
The stock doesn't care what you paid for it.
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