Wednesday, July 15, 2009

Anchoring And The Earnings Two-Step

These last three trading days have shown how prevalent anchoring is. At the individual company level, managements of closely-watched popular stocks have become pretty good at massaging our anchoring biases. Just shoot out pessimistic guidance, and you've got the investment community anchored good. A temporary decline in the stock price can be chalked up to previous overoptimism. Then, once the guidance is settled into the players' minds, out comes the earnings report that beats the consensus. Punters fall for it so regularly, some traders try to make a living playing the Earnings Two-Step.

More broadly, there's a definite company-driven anchoring effect with respect to the entire market. Unlike a specific fact or figure, the relevant anchor is more abstract. If a well-watched company shoots up because it beat its numbers, or it's confounded famous analysts to the upside, then good news will be in the offing for the market in general. The anchor in question, whose specifics change from day to day, is the price of any such stock just before the good news is released. If said news triggers an upsurge, then this augur augurs well for the overall market.

Interestingly, this effect is more regularly evident on the upside than the downside...although sometimes the general market can be wrecked by a "slight disappointment" from a hot company. There are also traders who play the averages using this anchoring effect as a kind of schtick.

Aside from interest taken in the human comedy, the effect of anchoring in the stock market only has an indirect impact on value investing. This bias sometimes makes stocks go on sale, and sometimes gets Mr. Market manic enough to offer a good price. The more relevant point is that it's possible for an abstract principle to serve as an anchor. In my relatively fatalistic entry on anchoring, I observed that many value investors are anchored on the idea of buying a dollar for fifty cents. Like all abstract anchoring, this principle serves as a benchmark used to measure something up - in this case, a potential value stock. Perhaps I took this approach because I'm reconciled to being easily anchored myself, but I believe that the effect can be useful if used properly. At a much more active (and risky) level, the above-mentioned traders try to do so too.

Some others, like Ben at the Inoculated Investor, concentrate on shaking off anchoring bias. His well-written cautionary discussion can be found here.

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