Anchoring Bias and their effects on Investment Decisions
Created on 17 Sep 2020
Wraps up in 4 Min
Read by 13.5k people
Updated on 11 Sep 2022
Do you know when Mahatma Gandhi was born? Let us suppose you don't have the year in your head, and your smartphone battery has just died. How would you find out? Perhaps you know that India got independence in 1947 and that he was assassinated the next year in 1948. And in all the pictures you have ever seen of him from that time, he looked pretty old. So let's assume that he was around 80 when he died—making 1888 our year of estimate when he was born.
Whatever the correct answer may be, the point of this example is the way we derived our solution. We found a reference point, in this case, in 1947, as the year of Indian independence, and walked towards an educated guess. Whenever we try to guess something, we use anchors. We start with something that we know and move on to unfamiliar territories.
What is Anchoring Bias?
A psychologist Amos Tversky experimented to see the effect of anchoring on individuals' decision-making. He took a spinning wheel and asked his participants to spin it. Later, he asked people to estimate how many African countries were part of the United Nations. Their guesses confirmed the anchoring effect. The highest estimates came from people who had spun high numbers on the wheel. Here, an irrelevant anchor has influenced their thinking.
Amos Tversky and Daniel Kahneman in 1974 found out that the predictions of different individuals are prone to a systematic bias, which leads them to predictable forecast errors. And one of the most common systematic biases that influence individuals' predictions is "anchoring" or choosing forecasts.
Anchoring bias indicates that an individual relies too much on the recent or initial information which has been given to them and makes decisions based on the same information. Anchoring bias occurs when an individual offers importance to unnecessary details, which leads to errors in decision-making.
A widespread example of anchoring bias is when we see any individual with shabby clothes; we automatically tend to assume that he might be poor or a financially weak individual. On the other hand, if we see somebody with expensive clothes and accessories, we think that he/she is rich. But this might not be the case as there might be a possibility that the person with expensive accessories might have rented those.
Likewise, we usually interpret that if a person is wearing glasses is intelligent, which may or may not be the case.
Effect of Anchoring Bias on our investments
While shopping on online platforms, have you ever noticed that the MRP is always higher for most of the items, then there is a discount price, and at last, they show how much you are saving?
But the reality is when you see the higher MRP, you start believing that the item is costly and you are getting a good discount on that item. However, this might not be true. This is known as price anchoring, which companies use to increase their sales.
While buying any stock, many investors first start by seeing the 52 weeks high or low price of that particular stock. This initial information is "anchor." Then they adjust this anchor up or down according to the further information they might receive. Do you also do the same?
Many investors anchor their choices based on irrelevant figures or statistics. For example, the highest price ever paid for a security will be a misleading anchor. Misleading because it makes the current price look cheap, even though the security could still be overvalued.
Analyst forecasts also serve as powerful anchors. The experts who come on any news channel program and talk about any particular sector or industry make investors anchored to their information, which might not be accurate. And most of the investors don't tend to research on their own. Sometimes past experiences also serve as an anchor.
What can you do to keep yourself protected from irrelevant anchoring Bias?
- Be aware that you are extremely sensitive to anchors that so-called experts offer on television news shows. Expert opinions, especially in investments, have louse track records. History shows that you might flip a coin. So be extra careful when you hear stock market experts talk about the future.
- If an analyst or salesman says that a stock has the potential to skyrocket, be sensible. This sentence might cloud your independent judgment. If this analyst or salesman had such foresight, he wouldn't be working as an analyst or a salesman anymore.
- Investors can practice critical thinking to avoid errors. Critical thinking means that if everyone is talking just positively about something, one must try to find out negative points in it as well. This will give an investor a broader view of the whole scenario.
- When any stock you hold goes down or goes up, to avoid price anchoring of the stock, investors must review their stock fundamentals carefully and then take any buy or sell decision.
It is always useful to have some kind of consciousness with you, but you should not let it work against you. Anchors are an excellent tool for making estimates of the future. The problem is you must be aware of irrelevant anchors that might influence you. There is no substitute for critical thinking to keep your investments firmly anchored.
So the next time you find a stock very cheap or if you hear any news or seek any expert advice, just give yourself a minute and try to think critically to make the right decision. Several other biases tend to create errors in investors' decision-making. They will be discussed in our upcoming blogs.
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