April 12, 2018

Why is Stock Price is Swinging Up and Down?

Pendulum from Canva.com

There was a chapter in the book “Thinking, Fast and Slow” written by Daniel Kahneman (published 2011), that talks about a phenomenal event that is very observable in stock market, the “Anchoring Effect”. According the Kahneman, anchoring “occurs when people consider a particular value for an unknown quantity before estimating that quantity”. 

Anchoring happens in stock market when we accept the price of a stock based on the momentary price that we see on the screen without further validation if the price of a stock is reasonable. That is, the present price that we are seeing is serving as the anchor. For example, some stock players buy stocks without comparing prices or looking at financials of the company. It might happen that you have bought a stock at higher price with lower value (the rational choice is to buy a high value company at a bargain price). If you bought company A at higher price compared to company B; and company B’s asset and income is higher compared to company A, that means that you have made a wrong choice.

Easy illustrated than practiced in the real world, preventing one’s self to be anchored on the stock price is difficult. That is the reason why some people lose their money on stock market. They were anchored by soaring prices believing that it will still go up. To combat this phenomenal anchoring effect, we should ask our selves if the price of stock is right. And if you find your self in doubt, don’t invest – make sure first that the price is right by doing research. If you still doubt your research – don’t invest. Remember that worthwhile investment should be based on sound research.

Daniel Kahneman is a well known for his work in behavioral economics in which he was awarded a Nobel Memorial Prize in Economic Sciences.

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