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ANCHORING EFFECTS IN STOCK RETURN ESTIMATES

Charles Bradley is a Finance student who loves to play the stock market in his spare time. He likes the thrill of rapid price movements and he knows that if he can catch the right price to buy and sell he will make lot of money. Charles has a strong interest in irrational financial decision making and the systematic errors that market participants make. These errors do not only affect stock prices and returns, they also create market inefficiencies. Charles is convinced that at some time or another he will be able to take advantage of these inefficiencies.

Charles is currently engaged in a research project on anchoring. Anchoring is a term used in psychology to describe the common human tendency to rely too heavily, or anchor, on specific information when making decisions, even though this information may have no logical relevance to the decision at hand. People often anchor, or overly rely, on a specific value for instance a recent stock price - and then adjust to that value; once the anchor is set there is a bias toward that anchor. Along these lines, investors frequently invest in the stocks of companies that have fallen considerably in a very short amount of time. In this case, investors are anchoring on a recent "high" that the stock has achieved and consequently believe that the drop in price provides an opportunity to buy the stock at a discount.

Charles sometimes feels that anchoring is likedriving a car only by looking in the rear view mirror; it will only show you what is behind you. He believes that if one drives ones car based only on what one sees in the rear view mirror, one will end up with an accident. In the late 1990s, for example, the stock market was going up and investors simply jumped on the bandwagon and kept buying more and more shares, Charles explains to his roommate and best friend David. Even though this resulted in a stock market bubble, investors general tendency was to just leave things be without making the effort to take any proper decisions with respect to asset allocation and riskdecisions that could have helped them to fare better in the future, when the markets turned. If investors anchor themselves to the idea that the market will keep going up, they will inevitably find themselves in a risk category that isnt the right fit for them, and theyll be putting themselves at a great risk when that market turns, Charles continued. Conversely, in a period of prolonged market downturn, people tend to anchor themselves to the idea that stock prices are just going to keep going down. This leads to an absolute disregard for investing in the equity market, and results in a situation where individuals end up in a risk category that does not fit them either.

Charles believes that what we are currently seeing is negative anchoring, where people are framing their investments in the context of the most recent financial crisis and all the negative news that they are constantly getting about the economy, unemployment, bankruptcies and the like.

Charles research project focuses on whether and how market participantslong-term stock return expectations are influenced by anchoring effects and to what extent expertise reduces these effects. After having developed a research proposal and a problem statement Charles is now ready to engage in a critical review of the literature.

QUESTION:

• Considering the "Anchoring Effects on Stock Return Estimates" case, discuss three different data sources that Charles could use and explain how Charles will benefit from using these data sources.