Investors Fall Victim To An Anchoring Bias When They Fail To Quantify The Effects Of Overvaluation

I stirred up some controversy when I said in a May 13, 2002, post to a Motley Fool retirement planning board that it is not possible to calculate the safe withdrawal rate accurately without taking into consideration the valuation level that applies on the day the retirement begins. One of the first questions that I was asked by skeptical community members was: “If you don’t think that the safe withdrawal rate for retirements beginning today is 4 percent, what do you think it is?”

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I didn’t know. As a result of those conversations, I hooked up with a systems engineer (John Walter Russell) who possessed greater statistical skills than I possess and together we developed a calculator revealing the true safe withdrawal rate at all of the various retirement starting-point valuation levels. But I didn’t have that information available to me at the time and so I tried to beg off responding to the question. But those asking it were persistent and eventually I buckled to the pressure. I said that I guessed that the safe withdrawal rate at the top of the bubble was probably something close to 3 percent.

The calculations that I did in development of the calculator showed that the correct answer was 1.6 percent. I was nowhere even close to the mark with my guess of 3 percent. If anyone believed me, I could have hurt that person in a very serious way. A safe withdrawal rate of 3 percent would permit someone with a $1 million portfolio to live the rest of his life on $30,000 spending per year. A safe withdrawal rate of 1.6 percent would only permit spending of $16,000 per year. I obviously view it as important to get retirement planning numbers correct or I never would have advanced my post challenging the numbers in the Buy-and-Hold studies in the first place. So why was I so careless as to venture forth with a number that was nowhere close to the mark?

I fell victim to “anchoring”. Wikipedia explains that: “anchoring is a cognitive bias for an individual to rely too heavily on an initial piece of information offered when making decisions…. During decision making, anchoring occurs when individuals use this initial piece of information to make subsequent judgments. Those objects near the anchor tend to be assimilated toward it and those further away tend to be displaced in the other direction. Once the value of this anchor is set, all future negotiations, arguments, estimates, etc. are discussed in relation to the anchor. This bias occurs when interpreting future information using this anchor. For example, the initial price offered for a used car, set either before or at the start of negotiations, sets an arbitrary focal point for all following discussions. Prices discussed in negotiations that are lower than the anchor may seem reasonable, perhaps even cheap to the buyer, even if said prices are still relatively higher than the actual market value of the car.”