Wednesday, September 17, 2008

Behavioral Finance and Trading: The Dangers of Anchoring

An excellent article from Investopedia summarizes the phenomenon of anchoring and how it affects financial decision making. (See the links at the bottom of that article for other posts on behavioral biases that influence trading and investment). Anchoring occurs when we become stuck to a particular reference point as a basis for making judgments and decisions. A very simple example that is common among traders is anchoring to an entry point after entering a position. Many traders will refuse to take a loss, instead waiting for the market to return to that entry point to allow them to scratch the trade. I've seen traders refuse to exit a bad position that moved to within ticks of their entry, fixed on exiting at the anchored point of entry. The result is that they often end up taking much larger losses when sheer pain becomes their stop-loss mechanism.

Salience plays an important role in anchoring: we are most likely to anchor decisions to criteria that capture our attention. For that reason, traders commonly anchor to high points and low points in market movements, including obvious points of support and resistance. Traders will gravitate to these points for the placement of their stops, as well as their entries for breakout trades. A useful behavioral rule is to assume that markets, in probing to establish value, will gravitate toward the price points of highest salience: those anchored by the largest numbers of traders.

At times, this probing can seem almost malicious, as if the market is trying to take out the largest number of stops and trigger the largest number of orders possible. One trader recently put it this way to me: the market will tend to move to the price region with the greatest volume of resting orders. If you think about how algorithms would need to be programmed to exit short-term trades, this makes sense. Furthermore, it would make sense for those resting orders to be placed just beyond those highly salient anchor points.

This makes anchoring a dangerous behavioral bias. If you anchor to a support or resistance level to enter a breakout trade, you may be completely unaware of the demand or supply that rests below or above those anchor levels. Similarly, if you place a stop near an obvious region of high or low prices, you may increase the odds that normal market probes will take out those levels in the search for value. In choppy markets, it pays to adopt a bit of a paranoid mindset: how could markets frustrate the greatest number of market participants. Usually they will do so by taking advantage of common behavioral biases, such as anchoring.


Attribution and Bias in Financial Decisions

Inside the Trader's Brain