A Guide To The 52-Week High And The Risks Of Anchoring

According to behavioural scientists, cognitive errors in humans can lead to duff decision-making. For investors, of course, this kind of weakness can end up being costly both mentally and financially. But while being aware of such flaws won't always save you from mistakes, it can offer at least some protection from making them.

There are few better places to explore just how big an impact 'behaviour' can have in the market than to look behind the scenes of the popular 52 Week High Momentum screen.

We track this strategy at Stockopedia, and it's up 20.9 percent over the past year - making it a top 20 performer. (It has returned 14.7 percent annualised over the past six years). It has also done well at resisting February's market volatility.

But like most momentum strategies, one of the interesting things about the 52-Week Highs approach is that it piggybacks on the behaviour of other investors. In particular, it takes advantage of what's known as Anchoring.

So, regardless of what you think about momentum (or whether you're even attracted by 52-week highs), knowing about Anchoring could change the way you think - consciously and unconsciously - about share prices. It can also explain, at least in part, why momentum is believed to be so powerful.

What is it about 52-week highs?

I've covered some of the inner workings of the 52-Week High screen a few times in the past (here's the most recent article). It's popular because the 52-week high is one of the most accessible data-points around. One-year highs are literally published all over the place - and they tend to catch the eye of investors.

But while the data for the strategy is readily available, the psychology that makes it useful is intricate. To a large degree, it calls on the 'momentum' investor to know that a share trading close to its 52-week high will probably sustain its upward trend over the near to medium term. But why would it do that?

The answer lies in what's called (mostly in academia) 'post earnings announcement drift' (PEAD). As the name suggests, this describes the slow, steady upward trend in a share price that often follows positive earnings news. In essence, it's the market taking much longer than usual to price in the full implications of the 'new' news.

To understand what's going on in this PEAD process, you can map it to something first observed by the psychologists Amos Tversky and Daniel Kahneman. Among many, many other things, they worked up the theory of anchoring-and-adjustment. They argued that humans form an anchor, or a belief, using a reference point (like a share price). As new information comes to light (like new earnings news), they only slowly adjust their beliefs away from that anchor point.

How and why anchoring works

Anchoring occurs in a variety of situations. It unfolds when we put too much importance on one particular piece of information (or price) - the anchor - and then start making estimates and adjusting our expectations (often badly) based on it.

One experiment showed that estate agents were particularly prone to it when it came to estimating fair market value of residential properties. In the research, agents were given a large amount of information about each property - including a site visit and the actual listing price. It turned out that the listing prices (which had been made up by the researchers) proved to be a huge anchor on the agents' estimates - meaning that they were often completely wrong.

In investing, research has argued that investors anchoring around the 52-week highs play a very influential role in the whole 'momentum effect'. Work by academics Thomas George and Chuan-Yang Hwang found that the 52-week high on its own causes irrational pricing behaviour because of investors who are anchoring and hesitant to bid the price up further. Over time, this emotional brake eases off, and the price drifts higher as momentum takes over.

Follow-up research by the same team found that companies that are trading close to new highs but go on to deliver positive earnings surprises are particularly likely to experience post earnings announcement drift.

For interest, I've picked a few names from the current top qualifiers in Stockopedia's 52 Week Highs and Earnings Surprise screens.

Name	Mkt Cap £m	###b#< vs. 52w High	Momentum Rank	Sector
Dewhurst	73.7	-	94	Industrials
Elektron Technology	47.3	-	78	Industrials
Dart (OTCPK:DRTGF)	1,178	-0.063	85	Industrials
Sky (OTCPK:SKYAY)	19,012	-0.32	93	Cyclicals
B&M European Value Retail	4,350	-0.32	82	Cyclicals

Click to enlarge

52 Week Highs

Name	Mkt Cap £m	EPS Surprise %, Last Interim	Sales Surprise %, Last Interim	EPS Surprise % Last Yr
Serica Energy (OTCPK:SQZZF)	217.3	684.3	19.8	684.3
Ergomed	95.5	126.4	16.8	61.7
Bloomsbury Publishing (OTC:BMBYF)	126.6	100.7	6.36	7.95
Future	174.4	92.2	13.6	31.0
CMC Markets (OTC:CCMMF)	443.9	21.9	18.0	7.99

Click to enlarge

Earnings Surprises

Making sense of anchoring and momentum

So what does this mean for investors? Well, for a start, it means that while the principle of the 52-Week High strategy is quite straightforward on paper, the execution is demanding. Investors using the 52-week high in their strategy need to believe that many other investors will be 'anchoring' around the 'new high', and it also needs that investor to not fall for the same trap. So, there is a fair amount of personal mental discipline involved.

But, in general, recognising the likelihood of anchoring-and-adjustment in the market - especially as a potential driver of momentum - can be useful. Events like 52-week highs and earnings surprises can set off a wave of irrational pricing caused at least in part by anchoring - which can either be avoided entirely or taken advantage of.

So, whether or not momentum is being used in a strategy, just knowing about the potential impact of behavioural flaws like anchoring (and the associated post earnings announcement drift) can be valuable.

It's worth remembering too, that because momentum is so heavily influenced by investor behaviour, when sentiment changes from positive to negative, the momentum can turn sharply. That's why some investors like to combine momentum with other driving factors like Quality and Value. That kind of blend may help to focus on stocks that are most likely to justify their new highs and may be better protected from the risks of sudden changes in sentiment further down the line.