Anchoring Bias in Behavioural Finance

The average investor may be able to keep their thinking in check and save themselves from a lot of biases. However, they still might not be aware of or be able to manage some of the more advanced biases. The anchoring bias is one such bias.

It affects the thinking of even the most sophisticated investors in the market. The problem with anchoring bias is that it is difficult to determine when a person’s decisions are based on facts and when the bias is taking over. In this article, we will have a look at the anchoring bias and how it impacts decision making.

What is Anchoring Bias?

An anchoring bias is a mental flaw that impacts the way a person derives the price of anything. For example, if a person goes to a shopping mall and they see that the price of a particular product to be $100 and then after a 50% discount they have to pay $50, they may be more inclined to buy the product.

This is because the discount makes the product appear cheaper and increases the value of the deal in the mind of the buyer. On the other hand, if the seller directly offered the product at a $50 price, then the seller might find the price to be expensive.

The anchoring bias is based on the fact that the first or initial information about the price of a product creates an anchor in our minds. We view all the subsequent information in the light of that anchor. This is particularly important in financial markets wherein people have to view prices and make buy and sell decisions every day.

Companies all over the world use anchoring bias to sell more products. This is the reason that e-commerce portals all over the world will write a higher price, then show and discount before they finally mention the selling price.

How Anchoring Bias Affects Financial Decisions

Anchoring bias can be very dangerous and can cause an investor to make rash financial decisions. Some of the possible flaws of the anchoring bias have been mentioned below:

• The main problem with anchors is that they are purely based on chance. They actually have no relation to the inherent, intrinsic value of a product.

• Anchoring bias causes investors to look at the past investment performance of a product and assume that it will continue to remain so in the future. For instance, in many parts of the world, real estate is under stress, and the prices have remained stagnant for some time.

  However, there are still a large number of investors who are anchored at past returns. Hence, even though there is no reason for the real estate sector to boom in the near future, investors may be biased because of its past performance.

• Anchoring bias causes people to delay selling their investment. They often hold on to a price and discount the time value of money. For instance, sometimes, an investor may hold on to an anchor price of $100 even though the market value at the time would be $85.

  The seller will keep on holding the stock and may sell at $100 after two years. In reality, there is no difference between selling at $85 and selling for $100 in two years as the money realized by selling at $85 could have been set aside for earning interest immediately.

  However, the investors get stuck on the price and get mental satisfaction only when that price is realized.

• Anchoring bias causes investors to take a lot of time to adjust to new information. Even if a company announces a major earnings increase, investors often are skeptical at giving a higher price to the company. This is because they are often anchored to a lower price based on the past investment performance of the company.

Overcoming Anchoring Bias

The root cause of the anchoring bias is the human need to form mental shortcuts. As human beings, we always find an approximate value and then adjust it to derive the value of a product. Hence, the most effective way to overcome the anchoring bias is to stop using shortcuts.

If an investor forms an opinion that is based less on shortcuts and more on due diligence, they are less likely to fall prey to this bias. As an investor, it would be better to perform a discounted cash flow analysis in order to determine the value of a stock than simply using the multiples approach.

Another way to avoid the anchoring effect is to also look at the macro factors before deciding upon a price. When the markets are in the boom phase, the assets are generally valued higher than they are when the markets are in the bust phase.

The bottom line is that it is very important for investors to be vigilant about the possibility that they may be irrationally anchored to a price based on a biased piece of information. If the person is not vigilant, then, over time, they might make certain bad decisions financially, which might impact their finances adversely.