Caravaggio's anchor

GUEST COLUMN

Investors not only use psychological anchors to price assets but they also overestimate individual capabilities.

Standing at the cathedral of Saint John's at Valletta in Malta, I was watching Caravaggio's masterpiece, 'The Beheading of St John the Baptist'. The painting is considered the first modern tragedy painting.

The 16th century artist was lost in notoriety till the time he was recognised 300 years later in 1920s. Standing there thinking about art, expression, poverty of an artist and the economics around it left me a bit confused. Dying in poverty and being worth millions in an after-life can only happen in this modern world.

Pricing an art work or a stock is similar. Markets work on pricing anchors on both individual and group levels. And recent studies have come to the conclusion that anchors are psychological biases, which are more inaccurate than accurate. We as a group and individual have a strong tendency to price assets on pre-conceived basis. In short, pricing is always more sentimental than rational.

Daniel Kahneman, the father of behavioural finance, talks about anchors in his award-winning work. Anchoring according to him is a cognitive bias that describes the common human tendency to rely too heavily, or "anchor" on one trait or piece of information when making decisions.

During normal decision making, individuals anchor, or overly rely, on specific information or a specific value and then adjust to that value to account for other elements of the circumstance. Usually once the anchor is set, there is a bias towards that value.

For a speculator, the Sensex is an anchor for the Indian stock market. Half of the 12 sector indices viz BSE Small-cap, BSE Mid-cap, CNX IT, BSE Auto, BSE Health care, BSE FMCG Indices are below their Apr 2006 prices. This 17-month sideways action had no bearing on the attractiveness of overall market and news around it. The Sensex anchor kept us as a group positive. The anchor of wealth is contagious.

It's like a person looking to buy a used car and focusing excessively on the odometer reading and model year of the car. He uses those criteria as a basis for evaluating the value of the car, rather than considering how well the engine or the transmission is maintained.

The simple act of thinking of the first number (aspect) strongly influences the second, even though there is no logical connection between them. This is what leads to the vicious extrapolation, which rarely prepares us for the future and invariably catches investors off-guard, like it did once again this July.

But the problem does not end here with value anchors. Don Moore, a professor at Carnegie Mellon University, illustrates the generally accepted conclusion that people believe themselves to be better than average, when effects are isolated to common behaviour and abilities, and that people believe themselves to be below average with respect to rare behaviour and uncommon abilities.

It's a high degree to which people overstate and engage in self-enhancement by believing that they are better than others when in fact they are not. The recent BusinessWeek study quotes 90 per cent of respondents claiming to be top 10 per cent performers at work.

Widespread better-than-average (BTA) effects have important practical implications. The notion that stock market investors believe that they are better than other investors at identifying the next great investment opportunity has been used to explain the high rate of trading in the stock market. The claim that managers believe they are better than others has been used to explain the high rate of corporate merger and acquisition activities.

The notion that disputants believe that their claims are more justified than are those of others has been used to account for the prevalence of lawsuits going to trial. And the belief that their armies are stronger than those of others has been invoked to explain nations' willingness to make the costly choice to go to war.

Especially in competitive situations, fooling yourself into believing that you are better than competition is likely to enhance your ability to engage in bluffs or intimidation.

On the other hand, people report themselves to be worse than others (WTA) at difficult tasks such as computer programming, coping with the death of a loved one, living past the age of 100, or being a part of a crisis or a great depression.

The good BTA effects often disappear entirely for events over which people have no control. Indeed, some evidence suggests that downward comparisons can actually lead people to feel better by reducing stress or increasing self-esteem.

Outcome desirability is only one of the many ways in which motivation gets manipulated. For instance, "easy" industries result in heavier competition and higher rates of failure.

Evidence does suggest that industries, with which most people are familiar, such as restaurants, bars, and clothing retail, see persistent high rates of founding and failure. And since group decisions are more positive and often more biased than are those of individuals, the likelihood of going wrong as a group is a reality.

It was one of these positive group outcomes we challenged when we gave the call for the July correction. Now that we are down, the group is looking for global comparisons, reducing stress or increasing self-esteem.

After all appreciating art was never more important than the stress of the otherwise smart individual losing money. It was this same group that anchored on Caravaggio in good times just before the start of 'The Great Depression'.

The author is CEO, Orpheus Capitals, a global alternative research company.