Rational analysis is essential to making smart investment decisions. Unfortunately, our first reaction to a complicated situation, usually instinctive, often does not serve our best interests. The field of behavioral finance studies how and why we make economic decisions.

Researchers have identified dozens of mental shortcuts. One heuristic that the brain uses to solve complex evaluations is to make an initial guess and then adjust from that point as we receive additional information to find a better answer. This mental process is called “anchoring.”

Anchoring is one of the root psychological flaws that pushes otherwise brilliant people to make financial mistakes. It’s critical to admit this heuristic is hardwired in your brain or you will continue to succumb to it. To avoid making serious financial mistakes, you must become a vigilant contrarian.

In the mental process of anchoring, we begin with some tentative solution to our problem and then we seek a better or more accurate solution. For example, we walk onto a car lot and note the sticker price, and we use that number as our starting point for negotiations. We know we can buy the car for that amount, and we start the process of seeking to get a better price.

Studies have shown that the higher the first price we are given, the higher will be the final price we end up paying for the exact same item. Stores sometimes bump their prices 30% higher before a 30% off sale because they understand this principle. Sellers on eBay may set a “buy-it-now” price artificially high simply to induce higher competitive bids.

We use mental anchoring more when we are unfamiliar with what the right answer is supposed to be. Conversely, the antidote to anchoring is to have done your homework and be able to evaluate the anchors you are given. Doing your research online before setting foot on the car lot helps you step into the process with the ability to analyze the reasonableness of that sticker price.

To understand how paradoxically our minds can work, researchers have shown that even when we know the anchor is a completely random number, it still has a significant effect.

For example, ask a friend to use the last three digits of his Social Security number to form a date somewhere between A.D. 0 and 1000. Next, ask him if he thinks Attila the Hun died before or after that date. Finally, ask him what year he thinks Attila the Hun died. People with a higher last three digits of their Social Security number tend to guess a much higher date for Attila the Hun’s death.

We are not rational creatures.

The antidote for this type of anchoring is doing the extra analysis to evaluate the answer more rationally. In other words, those who actually know the date of Attila the Hun’s death do not succumb to the mental fallacy of anchoring on the last three digits of their Social Security number.

Anchoring is like finding ourselves sitting in a chair in a pitch-black room. When we stand up, we keep one hand on the chair and reach as far as we can in each direction to try to get a feel for our location. The anchor of the chair keeps us from straying too far from our original point. The answer, of course, is to turn on the lights.

Most investors feel like they are in the dark. Sometimes having too much information to evaluate equates with having no information at all. Consequently, we anchor on the latest market movements or the high-water mark of what something was worth.

Although nearly all of us seem to say we are long-term investors, our tendency is to be swayed emotionally by the most recent short-term movements in the markets. We want to invest more in sectors that have recently been doing well, and we want to avoid, eliminate or reduce sectors that have recently dropped in value.

One study found that because of moving in and out of mutual funds at exactly the wrong moments, investors in mutual funds experience returns that underperform the very funds they were invested in, by 2.2 percentage points annually.

Funds are more likely to take new deposits after performing well but less likely to perform that well going forward. Similarly, funds that have not performed as well take in much less in deposits or have net redemptions but usually do not continue to underperform quite as badly. Investors experience returns that underperform because they buy the fund high and sell it low.

This isn’t to say you should stay in a poor mutual fund with high fees and expenses. But moving in and out of mutual funds to catch hot sectors of the economy produces returns that badly underperform a simple buy-and-rebalance strategy.

Even the investment news falls into the trap of describing past performance in the present tense. They say, “This stock is going up” or “This stock is plummeting” when what they really intend is simply to describe the most recent short-term past trend.

Given that 98% of daily stock market movements are noise, for long-term investors this is like saying, “We are bumping to the left” when driving on an old gravel road. Monthly stock movements are no better. They are 76% noise. Again, for a long-term investor, talking about monthly stock movements can be likened to saying, “We are curving right” when driving on a winding country road. Even annual returns have about 46% noise. Sometimes you need to drive south for an hour before you pick up the interstate. Only when you start looking over a 10-year time horizon can you safely describe your direction and say, “We are heading west.”

Investors tend to fixate on relative past performance. If their portfolios have gone straight from 100,000 to 120,000 over the past year, they are happy. If their portfolios rose to 150,000 before dropping back to 120,000, however, they are upset and depressed. People anchor to the high-water mark of their portfolios and are only satisfied when they hit an all-time high.

Avoiding the mistakes that stem from anchoring requires adopting an investment philosophy that does not depend on historical prices and past performance. Adopt an investment philosophy that dampens rather than amplifies trends. If your philosophy is to panic and sell at corrections and then wait to get back into the markets after they are appreciating again, your emotions amplify any losses.

Learn to be a contrarian and rebalance your portfolio regularly. Set buy and sell targets. Monitor an objective stock evaluation. Pretend you don’t already own it and you have to buy it at the current price. Make half a mistake, sell some and take some profit off the table.

One of the first principles of investing is humility. Knowing that your first instinct is probably wrong, doing nothing is often better than doing something quickly. Hence minimizing trading, being patient and investing in the markets going up is an excellent way to tune out the noise of short-term movements.

Second, if your instincts are often wrong, and the markets are inherently volatile, plan on some of your investments losing money. Therefore avoid leverage or options that could amplify a mistake to a loss that might jeopardize your financial goals.

Finally, practice setting an asset allocation that provides diversification. Regular rebalancing to a target allocation gives you the best chance of meeting your goals and an objective standard to practice contrarian investing by selling what has gone up and buying what has gone down.

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See also:

• Behavioral Finance: Mental Accounting

• Behavioral Finance: Overconfidence

• Behavioral Finance: Herd Mentality

• Behavioral Finance: Patience Is Its Own Reward