Don’t let anchoring tie you down

Today I wanted to touch on another common behavioral issue that most investors fall prey to, anchoring. I’ve commented previously on the behavior gap, how behavioral issues lead to investor under performance and specifically how more information often leads to worse investment performance. Anchoring is another behavioral pitfall for investors. I’ll describe what it is first and then show a common way it affects income investors.

Anchoring describes the effect of irrelevant numbers in people’s behavior. It turns out that irrelevant numbers impact our decision making in dramatic ways. James Montier in this piece on behavioral issues uses the following example.

Firstly, when it comes to anchoring we know that irrelevant numbers can influence people’s behaviour. For instance, Englich, Mussweiler and Strack1 show that legal experts were influenced by irrelevant anchors when setting jail sentences even when the experts were fully aware of the irrelevance of the input. In one study, participants (judges) were asked to role dice to determine the sentencing request from the prosecution. The pair of dice they used were loaded to either give a low number (1, 2) or a high number (3, 6). Having rolled the dice, participants were told to sum the scores and this number represented the prosecutions demand. Since the judges themselves rolled the dice, they could clearly see the input was totally irrelevant. However, the group who received the total score of 3 issued an average sentence of 5.3 months; those who received a total score of 9 issued an average sentence of 7.8 months!

With the flood of information in today’s markets investors have the chance to anchor to multitudes of irrelevant numbers; market forecasts, economic numbers, election results, etc…The scary thing is that we succumb to the effects of anchoring even when we know the inputs are irrelevant. So, what is an investor to do? One solution is to anchor to something that we know matters. How about dividends? As Montier says,

this is a really radical idea, how about we anchor share values in something we can measure like dividends! Since we know people will stumble into the pitfall of anchoring, our best hope is getting them to anchor to something vaguely sensible. Support for this idea is offered by the work of Hirota and Sunder2. They show that in experimental markets, bubbles are much more likely to appear when investors lack dividends as an anchor.

That is right up my alley and is yet another reason that dividend stocks form the core of my investment strategy. But even when you make the shift to anchor to dividends there is a very common pitfall to be aware of. The big pitfall is failing to roll forward the valuation of dividend stocks to account for the year’s dividend growth. The fair value of a dividend paying stock increases by the dividend growth rate every year, all else being equal. Say, a stock is priced at $10 with a 5% dividend and a 10% dividend growth rate. In one year, if the company meets its 10% div growth target, then the value of the stock goes to $11. See my post on the magic dividend formula is this doesn’t make sense. At the minimum, once a year an investor should re-look at their buy list prices and make adjustments accordingly. But sometimes even that is not enough.

Let me use Intel (INTC) as an example. In a recent post I went through a valuation analysis and stated that I would buy the shares at $19. At that time, Intel’s annualized dividend was $0.72 per share. This was already up from $0.632 at the end of 2010. I had used the $0.72 to come up with the $19 valuation. Then on May 11th Intel announced yet another increase to their dividend. This time to $0.84 annualized per share. That was a 16% increase shortly after the 15% increase from the end of 2010. Well, the pitfall here would be to anchor to that $19 a shares valuation and potentially miss out on an opportunity. Taking into account this mid year dividend hike the new valuation is approximately $22 a share all else being equal. Intel shares are currently trading below $22. While Intel shares are up from the pre-Q1 earnings levels of the high teems to low 20s, they are actually cheaper now. Sometimes this can be hard to comes to terms with but its very important to take into account with dividend paying stocks.

In summary, anchoring is another common behavioral issue that investor’s fall prey to all too often. And its practically impossible to avoid. Investors need a strategy and plan to deal with anchoring. A solution lies in training yourself to anchor to things that really matter, like dividends. And with respect to dividends an investor needs to account for the effect of dividend growth on the price levels of stocks.