What is Anchoring Bias?
Anchoring bias is the cognitive bias whereby a person places undue emphasis on the first information or cue, which is referred to as the “anchor,” that he or she gets to make decisions. Subsequent judgments and decisions become a variation on the anchor point established; such variation is irrespective of the appropriateness or inaccuracy of the anchor point. Anchoring bias has tremendous effects on the value set on stocks by investors, targets at price levels, and buy/sell decisions.
In other words, the term “anchoring” was used in the pioneering research conducted by two psychologists namely, Amos Tversky and Daniel Kahneman. They have described through demonstrations how people unconsciously cling to the first information-whether it is a numerical number, historical date, or simply contextual information-and do not alter that anchor completely based on the next relevant information.
For example, if an investor buys a stock that traded at ₹100, he continues to perceive the same stock to be his “fair value” even when it declines to ₹80 due to changes in market conditions. The investor will still continue to buy or hold based on the original price even after updating the financial data and changed fundamentals.
Anchoring bias appears all the way from simple everyday decisions to extreme investment decisions, where it results in low-quality financial decisions most of the time.
The Psychological Anchor: The Reason We Tend to Lean into Initial Information
Man’s, brain uses heuristics-an informal mental rule-of-thump-that reduces the cognitive costs of making decisions based on complex information. It is in anchoring-a heuristic that makes individuals seek an initial piece of information to anchor on, even when the item may not be relevant nor accurate.
The psychological factors behind anchoring bias are:
Reduced Cognitive Effort: Human beings are always trying to reduce the cognitive load at any instance while they are processing information. Anchors present a quick reference point, and therefore reduce the mental effort needed to analyse new data.
Confirmation Bias: After setting the anchor, individuals search for information that confirms their belief or reference point and avoid conflicting data.
Loss Aversion: Anchoring also has some relation with loss aversion. A person fears more from losses than gains. Suppose, a person buys a stock at ₹100 and it fell to ₹80. Then that person will not sell and waits for the stock to return back to ₹100 because he fears about making a loss.
Framing Effect: How information is framed supports an anchor. For example, if it is stated that a stock has “dipped from ₹100 to ₹80,” the reader would focus on the initial price rather than the fundamentals of the stock.
An anchor could come from past prices, analyst forecasts, or experience. Once an anchor has been established, it is hard to overcome because the brain typically makes incrementally small adjustments from an anchor point rather than trying to reset the situation from scratch.
Stock Market and Trading Examples of Anchoring Bias
Anchoring bias is quite prevalent in the equity market and trading. Indeed, most investors tend to get anchored to initial price points or benchmarks or market projections while investing. Here are a few examples:
Initial Buying Price: The investor purchases a stock at ₹100 and anchors it as the price for the fair value. In case it falls to ₹80, the investor may not want to sell it; he will hold onto his stock expecting the price to “recover” to his anchored point. It becomes a source of anchoring, as the investor usually holds an underperforming stock for much longer.
Example: A stock drops 20% from its high in the correction of the market. The investor anchored on this earlier high is still holding on to it, expecting it to rebound at that level while the broad trend has already indicated this decline.
Target Prices by Analysts: The expectation of investors gets anchored to analysts’ price targets. If an analyst feels that a stock would reach ₹200, for instance, an investor would anchor his decision on the same figure even if it is speculative and the market environment changes.
52-Week Highs and Lows: A high or low is all a number of investors care about; a stock trading at ₹150 and down from its 52-week high of ₹200 may look “cheap,” even if the drop merely reflects fundamental problems with the company.
Market Bubbles and Speculative Assets: During this period of irrational exuberance, investors tend to anchor towards unrealistic prices based on recent trends. For example, during the cryptocurrency mania in 2017, traders anchored on the ₹14 lakh value for Bitcoin assuming that it cannot come down and would increase further in the future and, therefore did not pay any heed towards the possibility of volatility or correction.
These are but a few of many ways in which anchoring bias skews rational decision-making and leaves the investor making decisions that do not align with objective market analysis.
Risks of Anchoring Bias in Financial Decisions
There are a few significant potential drawbacks of anchoring bias when applied to financial decisions, particularly in causing investors to fail to adjust when new information is received. Most of these risks are associated with:
Over-invested Holdings: Anchoring an investor to their acquisition may mean that the losing shareholder of bad-performing stock never leaves in anticipation that is returning to their initial holding prices. Emotions make these people shun losses and reinvestment; all efforts of moving money and equities elsewhere are foreclosed.
Over-Valuing: The period might finally generate an overpricing anchoring; the speculative may be unconscious of correction signs hence promoting overprice bubbles of unstable markets.
Missed Opportunities: An investor who is anchored to a prior price level does not have the courage to buy relatively undervalued assets. For instance, if stock A fell from ₹ 100 to ₹ 80, that could be an excellent buying opportunity, but for investor A anchored at ₹ 100, he would call the investment awful.
Ignoring Fundamental Changes: Anchoring does not enable investors to reassess the fundamentals of a company. If the financial health of a company worsens, the investors might end up anchored to historical data rather than changing their expectations.
Poor Portfolio Management: Anchoring bias leads to imbalanced portfolios, as investors hold onto specific assets or sectors due to past price references, which in turn leads to missed diversification opportunities.
The dangers of anchoring bias amplify in volatile markets, where the very investor has to constantly reassess a strategy due to changed conditions.
Anchoring Bias vs. Flexibility of Thought
Anchoring bias needs to be differentiated by flexibility of thought in financial decision-making:
Anchoring Bias:
• Focuses on some first reference point, thus getting rigid in decision making.
• Ignoring new data or changes.
• Leads to wrong choices due to an emotional attachment towards past prices.
Flexibility in Thought
• Has always tended to continually reassess a decision given new information and thought.
• Has tended to stimulate adaptability and rational examination.
• Helps investors understand that when certain assumptions are no longer correct and adjust appropriately.
Example: An investor anchored on a price of ₹100 for the stock will not sell. Although new information might have reduced its growth prospects, the investor will sell when the company’s revised growth prospects come out.
Flexible Investor will re-evaluate the stock by updating the data and decisions according to changes in new realities.
How an Investment Decision Breaks Loose from Anchoring Effect
Overcoming anchoring bias requires investors to use techniques that help in rational decision making and reduce reliance on arbitrary reference points. Some of the important strategies include:
Focus on Fundamentals: Investors should rely more on a company’s financial health, industry trends, and growth prospects rather than historical price references. Fundamental analysis helps an investor make decisions based on objective data rather than on emotional anchors.
Set Rational Benchmarks: Invest in real valuation metrics like P/E ratios, growth in revenue, and cash inflow rather than relying on purchase prices or analyst forecasting.
Be Open to New Information: Strong investors stay fluid and receptive to new information. The regular examination of investments against prevailing data in the market will sidestep pitfalls that typically arise from anchoring bias.
Always think in the long term: often the short-term view creates the anchoring. Taking a long-term perspective helps the investor look at broader trends and avoid being swayed by temporary price movements.
Stop-Loss Orders. Such would help an investor automatically restrain losses through selling the particular stock when its price becomes adverse enough to cut emotion-driven decision-making.
Independent Seeking Advisors/ Analyst: Sometimes it is helpful to see from the outside. Consultants can help avoid getting focused on irrelevant anchors.
How to Limit Anchoring Bias
All the above strategies help, in addition to which investors may educate themselves about cognitive biases. Getting informed about the anchoring bias and the other behavioural tendencies improves a sense of an investor’s identification as well as controlling these patterns.
Diversify Information Sources. This is one way that anchors the risk of being a single perspective. Investors can rely on financial reports, market analysis, and expert opinions before making a decision.
Reframe Decisions: Deliberately reframe investment decisions to challenge existing anchors. One can ask, “At what percentage is this stock trading from my purchase price?” investors can ask, “Is this stock still a good investment given its current fundamentals and market conditions?”
Don’t Depend on History: Background might come through history, but that alone mustn’t be a decision-driving element. Investors must rely more on forward-looking metrics, where their potential for growth, than looking at history of prices.
Have a Growth Mindset: The fact that mistakes and losses are part of the learning curve helps investors overcome their anchors. Viewing investments as avenues for growth rather than dwelling on past decisions brings about better long-term strategies.
Regular Portfolio Reviews: Periodic reviews of investment portfolios encourage investors to review holdings based on current market conditions and updated data. This habit reduces the emotional attachment to past price anchors.
Use Data-Driven Tools: Make use of technology and investing tools in order to objectively calculate the stocks. Financial software’s and platforms will give non-biased insights for the investor so that emotional decision making based on an anchor does not occur.
Conclusion
Anchoring bias is one of the most pervasive cognitive biases that goes to warp financial decision-making by anchoring investors to irrelevant or stale reference points. Understanding the psychological roots of this phenomenon and its presence is helpful for investors to take proactive steps against its impact. Strategies for more rational and flexible decision-making are focusing on fundamentals, reframing decisions, getting diverse perspectives, and leveraging data-driven tools. The ability of overcoming anchoring bias shall improve not only individual results of investments but also shall go towards a more balanced, efficient approach to managing any portfolio.
Frequently Asked Questions
1. What is an example of anchoring bias?
One example of anchoring bias is when an investor purchases a stock at ₹100 and perceives this price as the “fair value.” The investor may not sell the stock at ₹80, anticipating the stock to regain the purchasing price even though the market conditions or fundamentals show otherwise.
2. What is behavioural bias in finance?
Behavioural finance is a systematic bias in judgment or decision making as a result of cognitive or emotional factors. Very important bias includes overconfidence, loss aversion, and anchoring. Such cognitive or emotional biases affect the investor’s ability to take irrational decisions and thus allow less than optimum financial results.
3. What is the anchoring effect in behavioural economics?
It has been found in the arena of behavioural economics that people lean overmuch on the initial information, the “anchor,” and subsequent judgments are brought along with relative to this anchor-even when irrelevant or incorrect-for instance, the buyer might well believe he is getting an effective bargain at an offer price of ₹1,000 if the high price has been shown to have been ₹1,500-the true value of the thing is irrelevant.
4. What is anchoring and adjustment in behavioural finance?
The phenomenon of anchoring and adjustment is defined as the practice of how people first establish an anchor or starting value, then progressively adjust it from that point onwards to subsequent decisions. The problem is that adjustments are typically too minor, and the final judgment ends up being too close to the initial anchor. For instance, an analyst would take an old record high price of the stock and anchor the valuation thereof slightly downward rather than use the updated fundamentals to revise its current value.
5. What is anchoring bias in finance?
Anchoring bias, in finance, refers to the fact that an anchor or reference point is established at the beginning of things; most common would be a purchase price or historical price, for instance, or analyst target. Using this anchoring, the investor cannot make adequate responses to new information and, therefore, creates poor decisions that may include holding onto poor performers or missing opportunities.