WWII 068: Mitigating the Anchoring and Adjustment Bias, Netflix Raising Debt Not Issuing Equity, Bruce Greenwald

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Main Topic: Mitigating the Anchoring and Adjustment Bias

In this episode, I shine the light on the Anchoring and Adjustment Bias.

If you recall, in episode seventeen, I introduced you to 10 Biases that affect you as an investor. These are also known as Cognitive Biases, or Heuristics. One of the most prominent biases that cause us problems as investors is the Anchoring Bias. This bias is further complicated by an add-on called Adjustment.

In this episode, I will give you some concrete ways to mitigate this bias in your investing.

The Anchor Bias is a cognitive error in which we fixate on a target number or value – usually the first one we see. Here are some examples of the type of numbers we tend to anchor on:

1. The first time we see the stock price of a new idea.

2. The cost per share of the first position we take in a new idea.

3. The lowest point in a stock price in the last period of time.

4. An analyst’s estimate of earnings per share.

5. The price our friend bought a stock at and is bragging about it.

This is not a complete list, of course, but as you can see, there are ample opportunities to fall prey to anchoring cognitive bias for anyone in the investing game.

Anchoring on a particular number can cause problems in your portfolio. Here are some types of mistakes you might make because of the anchoring bias:

1. You start to buy at one price, then stop buying as the price falls and miss the opportunity to buy the same idea cheaper. You anchored on the initial price and felt fear as the price drifted below it.

2. You start to buy at one price, and the stock rises and you stop buying, anticipating it falling so you can continue to buy at your original cost, but the stock rises hundreds of percent and never falls to that first price again.

3. You have an idea that you want to buy, but you look at a chart and see the low was recent and you want to buy at the low, so you wait, and the stock never hits that price again and goes on to double.

4. You are holding on to a position at a loss and the facts changed. You are waiting for the price to reach your cost so you can sell and not have a loss. Sometimes your biases can overlap. In this case, you have both an anchoring bias and a loss aversion bias going on.

5. You do a discounted cash flow for an idea you are excited about (strike one). You have an expectation that this idea should produce a 20% IRR based on what others are saying about it. Your analysis results in only a 10% IRR. Even though you were accurate in your first DCF, you start tweaking the DCF until you are closer to the 20% IRR to get back to your original anchored expectation.

These are just five ideas for how anchoring can cause problems for investors. We all have them, and we all have to mitigate them. Sometimes we can mitigate them permanently, other times we have to be vigilant and stop them as they happen.

I mentioned that anchoring can be further complicated by adjustment. Example number five was adjustment in action. You anchored on a 20% IRR and then adjusted your DCF to meet that anchored expectation. This is especially dangerous when performing valuations of any kind. Our biases start to creep in to the numbers and could cause damage to your portfolio.

And I know this because as a human being, I have all of these biases and have made mistakes because of them. That is exactly why I now study them and search for ways to mitigate them.

Here are some ideas for mitigating the effect of the anchoring bias.

1. Warren Buffett uses the technique of using a company’s annual reports to estimate what the company is worth in a range BEFORE he looks at the stock price. This negates both the anchoring and adjusting bias. First, he estimates a range which keeps him from anchoring on just one number. Second, he eliminates the adjusting part by know what he wants to pay before he sees the price. With the valuation already done, he won’t be influenced by seeing the price.

2. Have a plan for when to sell as I discussed in the last episode number sixy-seven. Knowing the reasons and ranges that you will sell a position for will keep you from anchoring on the first price.

3. Calculate the intrinsic value of the company and the margin of safety that you require and the stock price you would be a willing buyer at or below. This will anchor you on the results of your analysis, not the stock price the first time you see it.

4. Keep a watch list with price you are willing to pay for each idea and set up an alert to notify you when it is close to that price so you are not constantly looking at price fluctuations.

5. Look at prices as infrequently as possible. If you get a new idea, don’t go look at the stock price immediately because you will likely anchor on it. Instead, put it on your idea list and do the work on it until you can put a valuation together. Only after you are confident you have a range for what you think it is worth, base a margin of safety calculation on the lower end of the range to get to the price you would be willing to pay. Add it to your watch list with that price, and only THEN check the price.

The study and mastery of cognitive biases is fundamental to becoming a better investor. These ideas will mitigate more than just the anchoring and adjustment bias that we fall prey to and I will talk about more about biases in future episodes.

We think, each of us, that we're much more rational than we are. And we think that we make our decisions because we have good reasons to make them. Even when it's the other way around. We believe in the reasons, because we've already made the decision.”

Daniel Kahneman

Ask JB: Why is Netflix raising debt, instead of issuing more equity, with the shares trading at these high levels

Why is Netflix happy to raise debt, instead of issuing more equity, with the shares trading at these high levels? (self.investing)

submitted 20 hours ago by Idontg1veafu

"Our debt to total cap ratio, at under 10%, is quite conservative compared to most of our media peers at 30-70%, and conservative compared to efficient capital structure theory. Thus we will continue to add long-term debt as needed to finance our expansion of original content, including in Q2."

JB Says: Popular companies like Netflix can issue debt at low coupon rates. Although interest rates have been rising, Netflix was still able to issue bonds at just over 4% coupon. Given that rates are rising, many companies will issue bonds in a race to lock in low-cost financing before rates rise much further. Netflix could issue stock instead given its ridiculous valuation in the market. At 22x book, and 144x Enterprise Value, they should issue a ton of stock instead of taking on debt because they would not be diluting shareholders, it will be incremental. My feeling is that Netflix’s management team is not good at allocating capital. Just my opinion but actions like this one make little sense to me.

Ask jb: Short a leveraged ETF to profit from beta slippage? (self.investing)

submitted 14 hours ago by QAFY

Sorry if this is a dumb question. Seeing as all leveraged ETFs suffer from beta slippage, can you use that to your advantage? For example, if you are bullish on an index, would shorting the inverse leveraged ETF work more to your advantage than buying the leveraged ETF itself? Profit as the inverse ETF goes down in value as well as profit generally from beta slippage (however minor it might be).

JB Says: This strategy used to work in the early days of leveraged ETFs. You are basically creating an arbitrage based on ETF decay. This arbitrage would still work if the following were true: you could borrow the stock of the inverse you are shorting, or you don’t have to pay margin interest. Unfortunately, you will have both problems. Most leveraged ETF shares are tough or impossible to borrow, and you will have to pay to borrow them at high (and potentially variable) rates. You could use options to potentially make this type of trade possible, but I’m not smart enough to figure out how to do that profitably without big risks and it’s also above my pay grade.

Do you have a burning question on investing you would like answered? Click the button below to send it to me and I will answer it on the podcast!

News: SNAP IPO fizzles and Bruce Greenwald Answers Questions

http://www.barrons.com/articles/bruce-greenwald-channeling-graham-and-dodd-1494649404

http://www.barrons.com/articles/snaps-25-plunge-isnt-an-invitation-to-buy-1494649442

About the Author

Jeremy Scott Bailey is an investor, author, entrepreneur and host of the "What Works In Investing?" podcast now available on iTunes. He is founder and Chief Investment Officer of Burgeón Group, Inc. an investment advisory firm that provides portfolio management services to families and individuals.

Leave a Reply 3 comments

Yaokai Jiang Reply

Hi Jeremy,
I think there is a bit of confusion around the netflix issue. While I agree that they should be issuing equity, but when they are talking about Debt to Equity of 10%, I don’t think they are referring to the market value of their equity, but rather the book value of their equity, which AFAIK are two different concepts.
Lemme know if I got it wrong.

    jbadmin Reply

    Hello Yaokai and thanks for commenting. I looked at NFLX latest Q filing and here is what I found:

    Total Long Term Debt of $3.4 Billion. Shareholders Equity of $3.0 Billion. So the Debt/Equity ratio would be 1.14 on a book basis (debt is 114% of equity).

    If we do the same calculation using market cap (market priced equity) of $70B, we get $3.3 Billion Debt / $70 Billion Market cap for a result of 4.7% (NFLX stock price has gone up a lot since I recorded that episode so the 10% has fallen to 5%). So I believe the “10%” comment really was based on market cap, not book.

    Does that clear it up for you? Agreed, issuing equity is the way to go!

      Yaokai Jiang Reply

      You are right! I should have looked at the numbers first.

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