Anchoring in Investing: Overview and Examples
A behavioral finance heuristic known as “anchoring” refers to the unconscious use of unimportant information, such as the price at which a security was purchased, as a fixed reference point (or “anchor”) for making choices regarding that security in the future. Therefore, if the proposed sticker price is $100 rather than $50, individuals are more likely to perceive the worth of the identical item to be higher.
An effective tactic in sales, pricing, and pay negotiations is anchoring. According to studies, establishing an anchor at the beginning of a negotiation might have a greater impact on the result than the subsequent negotiating process. A purposely too-high beginning point might limit the range of all subsequent counteroffers.
Anchoring: An Overview
An arbitrary benchmark, such a purchase price or sticker price, is given an excessively high weight in one’s decision-making process due to a cognitive bias known as anchoring. The idea is a component of the discipline of behavioral finance, which investigates the impact of non-economic elements like emotions on financial decisions.
One effect of anchoring in the context of investing is that market participants who exhibit an anchoring bias frequently hang onto assets that have declined in value as a result of their decision to base their fair value estimate on the initial price as opposed to fundamentals. As a result, market participants take on more risk by retaining the investment in the anticipation that the security would increase in value.
Market participants frequently seek to make revisions to reflect new information and analysis when they become aware that their anchor is flawed. However, results from these changes frequently exhibit the bias of the original anchors.
Bias in Anchoring
An anchoring bias can lead a participant in the financial market, such as a financial analyst or investor, to make a poor financial choice, such as purchasing or selling an investment that is overpriced. Anywhere in the financial decision-making process, from critical forecast inputs like sales volumes and commodity prices to final outputs like cash flow and security prices, anchoring bias can be found.
Common anchors include historical values like purchase prices or high water marks. This is true for values required to achieve a certain goal, such as realizing a target return or producing a specific sum of net profits. These values influence market players’ actions and are unrelated to market price.
With relative measurements, such as valuation multiples, anchoring may be present. When market participants disregard evidence suggesting one security has a higher potential for profits growth while employing a rule-of-thumb valuation multiple to assess security prices, they are exhibiting anchoring.
Many analysts advise investors to avoid some anchors because they might hurt investing objectives, such as absolute historical values and values required to achieve a goal. As market players navigate the complexity and uncertainty posed by an environment of information overload, additional anchoring might be useful. By determining the causes of the anchor and substituting measurable evidence for hypotheses, market players may combat anchoring bias.
To remove anchoring bias from investing decision-making, thorough analysis of the variables influencing markets or a security’s price is required.
Illustrations of Anchoring Bias
Examples of anchoring bias may be easily seen in daily life. Customers are frequently tied to a sales price based on the cost shown by a store or recommended by a salesperson. Regardless of the product’s true cost, any future negotiations will be based on that sum.
Anchoring bias manifests itself in a variety of ways in the realm of investment. Traders, for instance, are frequently tied to the price at which they purchased an asset. Regardless of the stock ABC’s true worth determined by an evaluation of pertinent elements or fundamentals impacting it, a trader who purchased stock ABC at $100 will remain psychologically fixated on that price when determining whether to sell or make subsequent purchases of the same stock.
In a different scenario, analysts can stop taking into account previous data in favor of being anchored to the value of a certain index at a certain level. For instance, experts will tend to estimate values that are closer to the S&P 500’s current value of 3,000 rather than taking into account the standard deviation of values, which has a rather broad range for that index.
Sales discussions also regularly use anchoring. A salesperson may initiate talks by making an extremely high offer that is objectively well over fair value. However, because the high price acts as an anchor, the ultimate selling price will often be greater than if the salesperson had first proposed a fair or low price.
When a recruiting manager or potential employee suggests an opening wage, a similar strategy may be used throughout the hiring process. The conversation may then be pushed back to that initial position by either party in an effort to arrive at an acceptable sum that was derived from the anchor.
How Can Anchoring Bias Be Prevented?
Even when people are made aware of the bias and consciously strive to avoid it, studies have shown that some factors can reduce anchoring, but it is challenging to completely eliminate it. In experimental investigations, explaining anchoring and asking participants to “consider the opposite” can lessen but not completely remove the impact of anchoring.
How Can I Benefit from Anchoring?
You can start with a higher asking price when negotiating a salary or selling anything since it will act as an anchor and likely to drive the final price higher. Instead of starting at a high level to minimize the anchoring effect, a buyer or hiring manager would start low.
What Do Anchoring and Modification Mean?
The anchoring and adjustment heuristic covers situations in which an anchor is later altered in light of fresh data until a desirable value is eventually attained. When the anchor is significantly different from the genuine or fair value, those changes frequently prove insufficient and stay too close to the original anchor.
- An unreasonable leaning toward an arbitrary benchmark value is referred to as anchoring in behavioral finance.
- This benchmark therefore distorts market participants’ judgments about a security, such as when to sell an investment.
- In pricing and sales negotiations, anchoring may be leveraged to your advantage by establishing an initial anchor that will impact later discussions in your favor.