|Gene: You gotta deal with those anchors!|
Our ancient monkey brains deal with this by grabbing something that is thought to be known - and extrapolating from there: a bias called 'anchoring'. The problem is that there is often little connection between 'what we think we know' and the rapidly changing real world.
Unscrupulous salesmen regularly use this weakness: by quoting a high price initially and then offering discounts, cheaper models and other deals, the price they end up offering seems more reasonable and attractive - although it may not be related at all to the actual cost of the item (or what you were prepared to pay in the first place).
In a 1974 paper entitled "Judgement Under Uncertainty: Heuristics And Biases", Kahneman and Tversky described how randomly selected numbers could significantly affect the estimates people make about unrelated questions - a higher random number leads to a higher estimate.
The DIY Income Investor approach is - and I say this candidly - based on a high degree of anchoring. Once the investment decision has been taken and the security has been bought, the enduring 'anchor' becomes the purchase price.
This is not always helpful. I judge the performance of the security by two key numbers: the change in value (caused by the change in the security price) and the current yield. The two numbers are obviously linked: if the price increases, the yield tends to fall. If the price increases enough (in relation to the annual income) I tend to grab a profit. However, if the price falls I tend to hold on - in denial almost (this is another behavioural bias called 'loss regret').
More experienced investors (and finance behavioural experts) will see the asymmetry that this produces. One result is a desolate section of my portfolio populated by impoverished former yield aristocrats who seem to have lost the will to live. The reality is that there was a point with all of these sad cases where I would (probably) have been better off selling them before the reality lost all connection with the anchor.
But here is the paradox: it's wrong but it seems to work, with more than a 50% total return over the last three years - although this is possibly an artifact of pure luck. It could probably be better, though.
In woodwork there is a concept of 'going with the grain' of the wood when shaping it or using a plane (a shaping blade): going against the grain is hard work (and likely to give you splinters). In a similar way. investing 'with the grain' of your behavioural biases is easier than trying to deny your evolutionary mental weaknesses. Hence the search for investment rules that modify - but do not completely oppose - our basic behaviour traits.
To repeat the outline of the DIY Income Investor approach:
- look for high-yield investment opportunities (dividend shares or fixed-income) - they are high-yield because they are perceived by the Market to be risky
- make your own assessment of risks, following a couple of basic 'rules' plus gut reaction
- buy and wait for the risk to evaporate and the price to recover (yes, mean reversion...) - the nice yield means that you are not too impatient for a result
- in the case of a price increase: sell when the price increase amounts to 5 times annual income unless you think there is a very good chance of 'more to come'
- in the case of a price fall: hold on (and on...), selling only when all hope of recovery seems lost or when (optimistically) the price recovers to the purchase price (the 'anchor')
My 'dogs' account for just under 5% of the portfolio, with an average loss of 60%. I have been able to sell several of them over the last year but the remaining offenders include RBS, LLOY, HOME, FGP, RSA, BARC and WMH. The bulk of this loss is due to one semi-failed bank: the 'Royal' Bank of Scotland, a disaster story registering an over 90% loss which is a continuing reminder that, yes, I should have sold this earlier.
So here is my idea for jettisoning this misplaced anchor that is probably dragging me down: I am considering a 'sell' rule when my loss reaches 10 times the annual income. Implementing this rule would result in the sale of most of my 'dogs'. More importantly, it would put in place a missing element in my investment strategy.
Does this proposal get your vote?
I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.