Biggest thrill of any markets, more so in case of equity markets, is its rapid price movements. This thrill is further enhanced by the fact that, it is easy for even a lay investor to participate in the equity market price movements.
Since price movement is rapid, individuals can recollect recently passed price points more easily. That causes anchoring effect. An anchoring effect from an investment perspective is one where an individual basis his/her decision 'only' on recent price point and makes an investment call.
For example, suppose price of SAIL Ltd is Rs 38.00. Company has had bad year last year. Investors remember last year and opts not to invest in SAIL Ltd. If price of SAIL Ltd starts moving up from Rs 38.00 to Rs 105.00, investor remembers Rs 38.00 and finds SAIL Ltd stock expensive.
The same investor when price of SAIL Ltd drops to Rs 85.00 from Rs 105.00, finds SAIL Ltd stock reasonable to "BUY," here investor has in mind price of Rs 105.00. Mind you this is the same investor who did not purchase SAIL Ltd at Rs 38.00.
We can also say that anchoring effect is like driving the car only by looking into rear view mirror driving based on what has passed-by. Rear view mirror will only show us what is behind us. If we keep driving our car based purely on what we see in rear view mirror, we will end up with an accident.
Anchoring effect shifts investor focus from long-term growth to short term price movement. Investor then starts believing that s/he will be able to make money by tracking price movement i.e. timing the market. Fact is no one can ever create wealth by timing the market. Wealth can be created by time-in the market. More the time you stay in the market, higher are the chances of creating long-term wealth.
One of the legendary fund managers of Wall Street, Peter Lynch had once said that while my fund has performed well, that is not rue for its investors. Peter Lynch was the fund manager of Fidelity Magellan Mutual Fund for about 13 years. This fund gave an average annualised return of 29%. Unfortunately, not all investors of Fidelity Magellan Mutual Fund got 29% annualised return during those 13 years. Many got much less because they tried to time the market and moved in and out of the fund.
Back home BSE Sensex, which was at about 2900 level in April 2003 is today (March 2007) around 13000 points. This is a growth of about 464% in absolute basis. Kindly check whether your entire equity portfolio has gone up by 464% or more in same time period. If your portfolio has not grown at 464% or more and with lesser risk, then all the efforts you made in stock/mutual fund schemes picking and timing the market has gone waste. You could have simply purchased BSE Sensex index fund and left it as it is.
Remember this important principal of investing -- "Real life long term returns is what investor does and not what portfolio does. . ."
The author is a Certified Financial Planner. He may be reached at gmashruwala@gmail.com