Is Anchoring Bias Weighing Down Your Investment Decisions?
If you’ve ever bought or sold a used item, you’ve likely encountered something called “anchoring bias.” Here’s how it works: Let’s say you need to purchase a used car for your son, who’s turning 16. You visit a car dealership and find a gently used SUV that would be perfect in the snow and would likely last your son through college. “How much is that SUV?” you ask the eager salesperson, hoping for an answer that’s within your budget. The salesperson knows she needs to get at least $22,500 to make a profit, so she responds with, “I can let it go for $25,000.” Boom — there’s the anchor. You were hoping for something closer to $20,000, but because you’ve anchored the value at $25,000, that’s where you start the negotiation. When you drive away with a final price of $23,000, you think you’ve gotten a better deal. The salesperson is also happy, because she made an extra $500 on top of her desired price.
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Q2 2020 hedge fund letters, conferences and more
Anchoring bias occurs when you assign too much weight to the first number presented in a discussion or negotiation, and then use that number (rightly or wrongly) as the point from which you adjust. In the car example above, $25,000 was the anchor point. But what if the Blue Book value of the car was only $15,000?
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Behavioral economists Amos Tversky and Daniel Kahneman discussed the concept of anchoring bias in 1974 in a paper entitled, “Judgment under Uncertainty: Heuristics and Biases.” In one exercise to demonstrate the effect of anchoring, the researchers asked subjects to spin a “wheel of fortune,” which landed on a number between 0 and 100. Then the researchers asked the group to estimate various quantities, stated in percentages, (for example, “What percentage of African countries is in the United Nations?”) and whether the percentage was higher or lower than the number that came up on the Wheel of Fortune. When the wheel stopped on the number 10, the participants decided, on average, that the percentage of African countries in the U.N. equaled 25%. When the wheel stopped on 65, their average guess was 45%. Even though the numbers on the wheel had nothing to do with the truth, they still had an effect on people’s estimates.
Anchoring Bias and the Stock Market
In my financial advisory practice, it’s not uncommon for us to talk with clients about the average expected return for their portfolios. For example, as this short video from Dimensional Fund Advisors explains, the U.S. stock market has returned 10% per year on average, since 1926. That, of course, doesn’t mean the return every year is 10%. The video goes on to show that returns in any given year have ranged from as high as 54% to as low as -43%. But that 10% average can be an anchor point, causing some clients to be disappointed if the number turns out to be only 8% in a certain year.
Investors who purchase and sell individual stocks may experience anchoring bias based on the original price per share that they paid. If a stock’s price was $75 per share when they acquired it, $75 becomes the anchor. Even if the stock is worth less now, they may decide to wait until the value reaches $75 per share again before selling it. In this case, the company’s fundamentals have nothing to do with the investor’s decision ¬¬— it’s all about the $75 he or she paid originally.
Tips to Avoid Anchoring Bias
Now that you understand the concept of anchoring bias, how can you keep it from creeping into your decision-making process? Are there times when you can use it to your advantage?
In a negotiation, you may be able to use anchoring bias to your benefit by throwing out the first number. And, according to Harvard Law School’s Daily Blog, you might have even better luck proposing a range instead of a single figure. Author Katie Shonk describes three different types of range offers: a bolstering range, which includes a single-figure offer at one end and a more ambitious number at the other end; a backdown range, which includes a single-figure offer at one end and a less ambitious number at the other end; or a bracketing range, which spans the single-figure offer.
When it comes to investing, a good first step toward avoiding anchoring bias is to become aware that it exists. When discussing value, averages, or any other type of number, recognize that you may be interpreting it as an anchor. Now comes the time to pause and dig deeper to challenge your assumption. What factors contribute to the number? Are they correct? Are they current?
When evaluating a stock price, don’t simply look at the 52-week high or the stock’s price the previous month. A stock’s value depends on several factors, including a company’s financial performance, economic trends, industry trends, and supply and demand. If something changes in any one of those areas, it could affect the value in either the short or long term. Instead of just looking at one number, look at the story behind it.
Take Carnival Corp., for example. If you had purchased the company’s stock in February 2020, you would have paid somewhere around $33 per share. But then came the coronavirus and its economic impact. The stock dipped to around $9.30 in March. As hope for a vaccine spiked, and the U.S. economy began to reopen, Carnival’s stock increased to near $25 per share in June, but has now leveled off in the $15 range, as the company evolves to meet new health and safety requirements and other factors.
You may think the stock is worth $33 per share, if that’s what you originally paid, but before you decide whether to keep it in hopes that it will reach that number again someday, do your research. Public companies, such as Carnival, provide updated financial and management information through their investor relations websites.
Anchoring bias can be a benefit or a bummer depending on how you use it. But now that you know what to look for, you can be ready. As Warren Buffett reportedly once said, “We try to avoid what is always the worst anchoring effect … which is our previous conclusions.” You can, too.