Exploring the concept of ANCHORING BIAS and its implications for investment decisions.
What is Anchoring Bias?
Anchoring bias is a cognitive bias that causes an individual to subconsciously use an initial piece of information as a fixed reference point or anchor in the process of decision making. A common example is the use of the purchase price of the security to make subsequent decisions about that security, such as when to sell the investment. Anchoring bias is an important concept in behavioral finance and encompasses how emotions can influence economic choices.
Anchoring Bias in Daily Life
It is easy to find anchoring bias in everyday life. It can be observed during sales negotiations. A salesperson deliberately states a price higher than the price the product ought to be sold at, keeping room for negotiation. This way negotiation for the final price begins, which is centered around the price initially mentioned. By anchoring, businesses would be able to earn a reasonable amount of profit from the sales made as negotiation for the product is based on the figure stated and not its actual cost.
Let us take a look at another example evident in our everyday setting. If we were to go to a shopping mall and find a product that was initially $20 but, with a 50% discount is now being offered at $10, we are more likely to perceive it as being cheap. It increases the value of the deal in our minds, and we would be highly interested in purchasing that product. On the other hand, if the same product was originally being offered at $10, we might have thought that the price was on the expensive side.
Hence, in both examples, we see how the first piece of information has been used for comparison and negotiation purposes that eventually lead to decision making. Like in our daily lives, anchoring bias is evident amongst investors that highly influence their investment decisions.
How does Anchoring Bias Affect Investment Decisions?
1. Delay in Selling an Investment
In the world of investing, market participants with anchoring bias tend to hold investments that have lost value. This is because they have anchored the fair value estimate of their securities to their original price rather than the fundamentals. As a result, market participants are exposed to a greater risk associated with the expectation of the security returning to its purchase price.
For instance, an investor will anchor to the price of $10 even if the current market value of the security is $7. The seller will hold on to the investment until the price increases to the original purchase price and may choose to sell it, even if it takes three years. Practically, there is no difference between selling the security for $10 in three years and selling it today at $7 as the money realized by selling it at $7 can be set aside for earning profit immediately from investing elsewhere. Thus, investors often hold on to the price and discount the time value of money.
2. Skewed Judgment / Wrong Financial Decisions
Historical values like the acquisition prices are well-known anchors. These values are unrelated to market pricing and thus, shouldn’t be given a lot of importance during decision making. However, market participants have investment objectives such as achieving a return as targeted or generating particular net proceeds, which is why these values are necessary for them, and they reject rational decisions.
For instance, traders generally anchor to the price at which they buy a security. If a trader has bought a security for $10, he will use this price as a benchmark to decide when to make additional purchases or sell the shares of the particular stock. If the market price of the same security reaches $8 today, the investor could decide to buy more shares since the market price appears to be cheap, however, the share could be overvalued. Therefore, we could end up purchasing an overvalued asset and may overlook an undervalued asset simply because we are fixated on the market price. During this process, an investor’s judgment is skewed as the value of the investment is being assessed with one single factor while there are a number of relevant factors one needs to consider.
3. Anchoring Leads to Other Investment Biases
Anchoring could lead to a number of other investment biases. For instance, anchors could lead to disposition bias which is the tendency to sell off the shares whose prices have risen and hold on to the stocks whose prices have dropped. Similarly, it encourages you to gather any information that aligns with your pre-conceived notion, known as confirmation bias. You will ignore any information that does not support your anchor; however, this piece of information may be a crucial determinant of the market price.
Therefore, anchoring bias leads financial market participants to use irrelevant information to invest. Sticking to an initial piece of information to make judgments and decisions regarding the security (when to buy and when to sell) will provide a false analysis since one is relying on a single piece of information while neglecting several other factors. As a consequence, financial analysts, investors, and traders make irrational decisions. It is due to this reason why being able to avoid this bias is extremely important when investing.
How to Avoid Anchoring?
Anchoring may happen when you are pressured to make a quick decision. Therefore, delay your decision. Use this time to accumulate information from several reliable sources. Also, do your research. Decisions must never be based on one sole factor. One should be open to new information, although it does not align with the initial information one is relying on to make decisions. Lastly, rely on metrics rather than emotions. Check the company’s fundamentals before buying or selling a security. Comprehensive research and evaluation of factors affecting markets or a security’s price are essential to eliminate anchoring bias from decision-making in the investment process.
