Week 33 Day 3: Anchoring: Why Your Purchase Price Is Irrelevant

You bought Bitcoin at $60,000. It drops to $30,000. You think, 'I will sell when it gets back to $60,000.' Why $60,000? Because that is what YOU paid. But 10 million other Bitcoin holders paid different prices. Your purchase price is meaningful to you and meaningless to the market.

How anchoring sabotages investment decisions: (1) Refusing to sell losers until 'break even.' The stock does not know your cost basis. If the fundamentals have deteriorated, holding until break-even may mean holding forever (or until zero). (2) Setting profit targets based on purchase price. 'I will sell when it doubles' is arbitrary. What if the stock is still undervalued at 2x? What if it is overvalued at 1.5x? Evaluate based on current value, not your entry point. (3) Averaging down without analysis. 'The stock dropped from $50 to $25, so it must be cheap!' Not necessarily. It might have dropped because the company is failing. Averaging down on a sinking ship just puts more money on the sinking ship. (4) Comparing to past prices. 'Amazon was $180 last year, so $150 is a bargain.' Last year's price is irrelevant. Tomorrow's earnings, growth rate, and competitive position determine value. The antidote: every investment decision should be based on forward-looking analysis, not backward-looking reference points. For index fund investors, this is simple: VTI's 'value' is always 'the entire U.S. stock market at market prices' -- there is no anchor to mislead you.

Anchoring was identified by Tversky and Kahneman (1974) as a fundamental judgment heuristic: when making numerical estimates, people start from an initial value (the anchor) and adjust insufficiently from it. In financial markets, Baker, Pan, and Wurgler (2012) showed that the anchoring effect is pervasive: companies setting IPO prices, analysts setting price targets, and investors making buy/sell decisions all demonstrate anchoring to recent prices, round numbers, and 52-week highs/lows. George and Hwang (2004) found that nearness to the 52-week high is a significant predictor of future returns even after controlling for momentum -- investors anchor to the 52-week high and underreact when prices approach it (reluctant to buy near the perceived 'ceiling') and overreact when prices are far below it (perceiving a bargain relative to the anchor). At the individual level, the purchase price as anchor creates the disposition effect (selling winners, holding losers) which Odean (1998) estimated costs the average individual investor approximately 3-4% per year in foregone returns. The tax implications compound the error: by holding losers and selling winners, investors maximize their current tax liability (realizing gains while deferring losses). The optimal behavior is the exact opposite: sell losers (harvest tax losses) and hold winners (defer tax on gains). A simple rule to de-anchor: never consider your purchase price when evaluating whether to hold or sell. Ask only: 'Given its current price, would I buy this today?' If no, sell.