Anchoring in Investing: Overview and Examples
[ad_1]
What Is Anchoring?
Anchoring is a heuristic in behavioral finance that describes the subconscious use of irrelevant information, such as the purchase price of a security, as a fixed reference point (or anchor) for making subsequent decisions about that security. Thus, people are more likely to estimate the value of the same item higher if the suggested sticker price is $100 than if it is $50.
In sales, price, and wage negotiations, anchoring can be a powerful tool. Studies have shown that setting an anchor at the outset of a negotiation can have more effect on the final outcome than the intervening negotiation process. Setting a starting point that is deliberately too high can affect the range of all subsequent counteroffers.
Key Takeaways
- Anchoring is a behavioral finance term to describe an irrational bias towards an arbitrary benchmark figure.
- This benchmark then skews decision-making regarding a security by market participants, such as when to sell the investment.
- Anchoring can be used to advantage in sales and price negotiations where setting an initial anchor can influence subsequent negotiations in your favor.
Understanding Anchoring
Anchoring is a cognitive bias in which the use of an arbitrary benchmark such as a purchase price or sticker price carries a disproportionately high weight in one’s decision-making process. The concept is part of the field of behavioral finance, which studies how emotions and other extraneous factors influence economic choices.
In the context of investing, one consequence of anchoring is that market participants with an anchoring bias tend to hold investments that have lost value because they have anchored their fair value estimate to the original price rather than to fundamentals. As a result, market participants assume greater risk by holding the investment in the hope the security will return to its purchase price.
Market participants are often aware that their anchor is imperfect and attempt to make adjustments to reflect subsequent information and analysis. However, these adjustments often produce outcomes that reflect the bias of the original anchors.
Anchoring is often paired with a heuristic known as adjusting, whereby the reference level or anchor is adjusted as conditions change and prices are re-evaluated.
Anchoring Bias
An anchoring bias can cause a financial market participant, such as a financial analyst or investor, to make an incorrect financial decision, such as buying an overvalued investment or selling an undervalued investment. Anchoring bias can be present anywhere in the financial decision-making process, from key forecast inputs, such as sales volumes and commodity prices, to final output like cash flow and security prices.
Historical values, such as acquisition prices or high-water marks, are common anchors. This holds for values necessary to accomplish a certain objective, such as achieving a target return or generating a particular amount of net proceeds. These values are unrelated to market pricing and cause market participants to reject rational decisions.
Anchoring can be present with relative metrics, such as valuation multiples. Market participants using a rule-of-thumb valuation multiple to evaluate securities prices demonstrate anchoring when they ignore evidence that one security has a greater potential for earnings growth.
Some anchors, such as absolute historical values and values necessary to accomplish an objective, can be harmful to investment objectives, and many analysts encourage investors to reject these types of anchors. Other anchors can be helpful as market participants deal with the complexity and uncertainty inherent in an environment of information overload. Market participants can counter anchoring bias by identifying the factors behind the anchor and replacing suppositions with quantifiable data.
Comprehensive research and assessment of factors affecting markets or a security’s price are necessary to eliminate anchoring bias from decision-making in the investment process.
Examples of Anchoring Bias
It is easy to find examples of anchoring bias in everyday life. Customers for a product or service are typically anchored to a sales price based on the price marked by a shop or suggested by a salesperson. Any further negotiation for the product is in relation to that figure, regardless of its actual cost.
Within the investing world, anchoring bias can take on several forms. For instance, traders are typically anchored to the price at which they bought a security. If a trader bought stock ABC for $100, then they will be psychologically fixated on that price for judging when to sell or make additional purchases of the same stock — regardless of ABC’s actual value based on an assessment of relevant factors or fundamentals affecting it.
In another case, analysts may become anchored to the value of a given index at a certain level instead of considering historical figures. For example, if the S&P 500 is on a bull run and has a value of 3,000, then analysts’ propensity will be to predict values closer to that figure rather than considering the standard deviation of values, which have a fairly wide range for that index.
Anchoring also appears frequently in sales negotiations. A salesman can offer a very high price to start negotiations that is objectively well above fair value. Yet, because the high price is an anchor, the final selling price will also tend to be higher than if the salesman had offered a fair or low price to start. A similar technique may be applied in hiring negotiations when a hiring manager or prospective hire proposes an initial salary. Either party may then push the discussion to that starting point, hoping to reach an agreeable amount that was derived from the anchor.
How Do You Avoid Anchoring Bias?
Studies have shown that some factors can mitigate anchoring, but it is difficult to avoid altogether, even when people are made aware of the bias and deliberately try to avoid it. In experimental studies, telling people about anchoring and advising them to “consider the opposite” can reduce, but not eliminate, the effect of anchoring.
How Can I Use Anchoring to My Advantage?
If you are selling something or negotiating a salary, you can start with a higher price than you expect to get as it will set an anchor that will tend to pull the final price up. If you are buying something or a hiring manager, you would instead start with a lowball level to induce the anchoring effect lower.
What Is Anchoring and Adjustment?
The anchoring and adjustment heuristic describes cases in which an anchor is subsequently adjusted based on new information until an acceptable value is reached over time. Often, those adjustments, however, prove inadequate and remain too close to the original anchor, which is a problem when the anchor is very different from the true or fair value.
Correction—July 21, 2022: This article was updated to make clear a risk of anchoring resulting in buying overvalued assets or selling undervalued ones, not buying undervalued assets and selling overvalued ones.
[ad_2]
Source link
Tags: ABC, Anchoring, Examples, Investing, Overview, stock, Understanding
Trackback from your site.
