Don't moor yourself to the wrong anchor

For a while there, it looked liked the market would continue to go straight up without pause. Last week, stocks—especially the beleaguered financials—were on a tear. This week, they’ve dropped back significantly (although they did rise +1% today). The market never goes straight up, and I’m actually pleased that we’re taking a breather, because investors were getting ahead of themselves. Think about it: in only 2 months, the S&P 500 had risen nearly +40%. It was time for a rest. As of today, the S&P 500 is “merely” up +34% from its March 9 low.

Whether this is a bear market rally or a nascent bull is beside the point; predicting short-term market moves is impossible anyway. The bears say the recovery will be too weak to justify a continued rise in stock prices. The bulls say that the market had priced in a depression, and we’re ending up with “just” a severe recession, meaning prices got too low and need to rise. Who knows and who really cares? Prices of nearly everything—not just stocks—dropped to depression-like levels. But now the global credit markets are clearly in recovery, and the economy will eventually follow. Already, it’s clear the economic cliff-dive that began last September has abated, the rate of decline has slowed dramatically, and some areas are already in an early uptrend. The world hasn’t come to an end (sorry, Dr. Doom).

It’s about now in the market cycle that investors again start making irrational decisions. Panic is just a memory, and despair is fading. Indecision is the order of the day. “Do I buy or do I sell? Do I take my money and run or do I put more to work now that the coast seems clear?” In trying to make these difficult decisions, many investors look to “anchors”: prices of individual assets and market indices that seem to have special significance. Problem is, these anchors are almost always meaningless and thus misleading.

For example, in early March the S&P 500 was at a bear market low of 666. Today it is at 893, a +34% gain in only 2 months. Many people say: “Too far, too fast. Must be a bear market rally.” These people have “anchored” that 666 value, giving it special meaning and significance. The unspoken assumption is that 666 was an accurate measure of the stock market’s value, and that the current level of 893 is thus too high because stocks shouldn’t rise so fast. But what real significance does 666 have, other than the level of the S&P on a particular day? Maybe 893 is closer to the market’s intrinsic value, or maybe the correct number is 1,000. We just don’t know, and of course, both current prices and intrinsic value change continuously.

The key point is that the market low of 666 is just an arbitrary, and basically meaningless, number. But people will be anchored to it and reference it for months and years to come. This “anchoring bias” is compounded by another cognitive error that investors typically make, called “recency bias.” This is the natural tendency to remember recent events more clearly and to weight them more heavily than more distant events. Remember when all the market pundits were referencing current prices to the bull market high of 1576 from October 2007? But today you don’t routinely hear that “stocks are cheap because they’re 43% below their highs.” Rather, they’re expensive “because stocks are 34% above their lows.” We anchor to the more recent number and tend to forget the older one. But in reality, both the high and low values are just arbitrary numbers of no significance except to statisticians and market historians.

We do the same thing with individual stocks, anchoring their highs and lows (emphasizing whichever of these is more recent). Take, for example, BHP Billiton, the world’s largest mining company. Many investors think it is becoming expensive because at a recent $50 per share, it’s doubled from a low of $25 in only 6 months. You don’t hear anyone saying it’s cheap because the stock is down 48% from a high of $96; that anchor is too far in the past. Again, these numbers should have no significance to the methodical investor, because there are only 2 prices of any importance: today’s, and what you think the stock will be worth in several years. Everything else is noise.

Another common anchor, perhaps the most often used (and abused), is the most meaningless of all: the price you paid for a stock. How often have you heard (or said), “I’ll sell the stock when it recovers to my purchase price” or “I’ll sell it after it doubles” or “I’ll sell it if it falls 20% below my purchase price.” If Mr. Market doesn’t care about high and low prices, how indifferent must he be to the price you paid? Basing a sell decision for a stock in relation to your purchase price makes no more sense than selling your house solely because it’s now worth twice what you paid. You should sell your house when you need to move, no matter what its current value. Similarly, the only reason to sell a particular stock is because you believe that the money would be better deployed elsewhere: in a different stock, in a different type of asset, or in consumption. The current price of the stock, whether in comparison to its recent high or low, or to your purchase price, is completely irrelevant. (It is relevant, however, in comparison to your assessment of the stock’s intrinsic value).

So don’t get too anchored; go with the flow, because prices and values are fluid. And don’t make the mistake of assuming that recent price movements have any impact on future prices. If a stock has recently doubled, it’s not necessarily expensive, but could potentially double again. Similarly, if it’s just fallen in half, it’s not necessarily cheap and worthy of purchase. It might halve again. In other words, random prices are just that: random. And “past performance does not predict future results” is totally true with individual stocks and the market as a whole. The future cares not a whit about the past, nor does Mr. Market, and neither should you.