Yet it’s a human trait to become fixated on particular numbers. In a Financial Times article, investment columnist John Authers describes the recent success of fund manager Tom Howard. Howard refuses to record the buying price for any equity held in his portfolio.
By ignoring whether a sale of that equity might crystallise a gain or a loss, Howard argues that he is able to take a more dispassionate decision as to whether to keep or sell it.
Many of us, by contrast, are reluctant to sell out of losing positions as it would mean admitting we’ve got things wrong.
Identifying and describing the human psychological trait called anchoring helped economist Daniel Kahneman win the Nobel Prize in 2002.
In a classic experiment conducted in the mid-1970s with co-researcher Amos Tversky, Kahneman asked participants in a survey to look at a roulette wheel (numbered from 1 to 100) that was set to stop at 10 or 65. After watching the wheel spin, participants were asked to guess the percentage of United Nations countries that are African.
Those observing the roulette wheel stopping at 10 guessed a lower percentage for Africa’s representation at the UN (25% of countries) than those seeing the wheel stop at 65 (this group said that 45% of UN countries were African).
Even though there’s obviously no connection between the wheel and the UN, Kahneman and Tversky suggested that humans often use a numerical “anchor” as the basis of assessing probabilities, even when this leads to contradictory or inconsistent results.
Fund manager Tom Howard’s decision to try to ignore whether the positions he holds are trading at an unrealized gain or loss is therefore in some sense a recognition of the power of anchoring (and a way of trying to counter this powerful psychological trait).
The implications of behavioral economics (Kahneman’s and Tversky’s area of study) for finance and investment are still being explored. It’s fair to say that the economists’ ideas have gained increasing acceptance at the expense of classical economic theory, which assumes that individual actors are entirely rational.
For users of financial indexes, the insights of behavioral finance are well worth reminding ourselves of. Indexes actual levels, which we hear mentioned every day, are valuable pieces of information but we must be careful not to assign excessive significance to particular numbers. It’s important to understand indexes key use: as an objective representation over time of a particular market segment. And past performance is no guide to the future.
© 2015 London Stock Exchange Group companies.
London Stock Exchange Group companies includes FTSE International Limited (“FTSE”), Frank Russell Company (“Russell”), MTS Next Limited (“MTS”), and FTSE TMX Global Debt Capital Markets Inc (“FTSE TMX”). All rights reserved.
“FTSE®”, “Russell®”, “MTS®”, “FTSE TMX®” and “FTSE Russell” and other service marks and trademarks related to the FTSE or Russell indexes are trademarks of the London Stock Exchange Group companies and are used by FTSE, MTS, FTSE TMX and Russell under license.
All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by the London Stock Exchange Group companies nor its licensors for any errors or for any loss from use of this publication.
Neither the London Stock Exchange Group companies nor any of their licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell Indexes or the fitness or suitability of the FTSE Russell Indexes for any particular purpose to which they might be put.
The London Stock Exchange Group companies do not provide investment advice and nothing in this communication should be taken as constituting financial or investment advice. The London Stock Exchange Group companies make no representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the London Stock Exchange Group companies. Distribution of the London Stock Exchange Group companies’ index values and the use of their indexes to create financial products require a license with FTSE, FTSE TMX, MTS and/or Russell and/or its licensors.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back-tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.