Anchoring Bias

Refers to relying too much on a previously known piece of information that may be irrelevant and use the information as an anchor for decision-making later on

Author: Austin Anderson
Austin Anderson
Austin Anderson
Consulting | Data Analysis

Austin has been working with Ernst & Young for over four years, starting as a senior consultant before being promoted to a manager. At EY, he focuses on strategy, process and operations improvement, and business transformation consulting services focused on health provider, payer, and public health organizations. Austin specializes in the health industry but supports clients across multiple industries.

Austin has a Bachelor of Science in Engineering and a Masters of Business Administration in Strategy, Management and Organization, both from the University of Michigan.

Reviewed By: Adin Lykken
Adin Lykken
Adin Lykken
Consulting | Private Equity

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The Boston Consulting Group as an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

Last Updated:December 13, 2023

What is Anchoring Bias?

Anchoring is a cognitive bias revealed by behavioral finance, wherein people rely too much on a previously known piece of information that may be irrelevant and use the information as an anchor for decision-making later on. 

The bias states that while making decisions, instead of interpreting newer information from a completely objective frame of mind, people tend to view the data from the reference point of the benchmark.

For example, if we see two pieces of cloth, the first for $200 and the second for $100. The first cloth is often viewed as a benchmark, and people may view the second cloth from the reference point of the first, thinking it is cheap.

At the same time, if someone is just shown the second cloth, they are not weighed down by the benchmark and can judge the material entirely on its merit and thus decide objectively whether it is cheap.

Key Takeaways

  • "Anchoring" is a cognitive bias wherein people rely too much on a previously known piece of information that may be irrelevant and use the information as a benchmark for decision-making later on. 
  • In the context of investing, this bias may be seen through historical prices, where a person may become anchored to the price they bought an investment at. 
  • This phenomenon may be caused by the process of anchoring and adjusting, selective accessibility, or simply the attitude or mood of the subject.
  • While eliminating the bias is near impossible, one can use it to their advantage or be less prone to it by providing arguments against the framework set.

Understanding Anchoring Bias

It is a part of behavioral finance, which studies how emotions influence decision-making and can lead a person to make choices that are not rational. 

It is when a cognitive bias in which a person creates a benchmark because a piece of information provided to them carries a disproportionate weight in their decision making. Due to this bias, a person makes all subsequent decisions from the reference point of the framework they created.

For example, if a person is buying a car, they may create a benchmark based on the first model they see. All subsequent models are viewed from the reference of the first model. 

Thus, if the first car was $200,000 and the second was $180,000, the consumer may believe the second car is cheaper. 

However, this is just because they are viewing the 2nd car relative to the 1st car, even though it may be possible that the 1st car was worth the money while the second was overpriced.

This is because, when we first get a piece of information, people tend to create specific frameworks and plans in their minds. 

All subsequent information thus gets distorted as people try to fit them into the pre-existing frameworks, i.e., we become anchored to specific frameworks.

In the context of investing, this phenomenon may be seen through historical prices. A person may become anchored to the price they bought an investment at rather than the actual value of that security. 

Examples

This bias is not only restricted to financial markets but can be seen everywhere, from product placements in a store to salary negotiations with a person's employer.

In the case of salary negotiations, research shows that the first person to make an offer can help to drive the conversation and can have the advantage. But, again, this is because of the anchoring effect. 

If the employee makes the offer, they create a benchmark in the employer's mind. Thus, all subsequent requests are made with the first offer in mind. 

Similarly, in product placement, if a product is kept next to a more expensive product, it is more likely to be purchased. Again, this is because the first product creates a benchmark in the minds of the consumers. 

Thus, the following product is seen from the reference to the first product and hence seems comparatively cheaper.

Anchoring bias in investing

In the context of investing, this bias can be seen in a variety of situations, and it can cause an investor to value the investment wrongly, hold an asset when they shouldn't, or buy and sell the wrong securities.

Some of these situations are as follows:

  • People may create a benchmark based on the original price they bought the investment at. Unfortunately, due to the model designed at the price the asset was purchased, people tend to hold investments that have lost their value in the hope that they will return to the price it was bought at, which increases the risk of the investor. 
  • Achieving a target return or specific objectives can cause an investor to make irrational decisions like holding on to an investment in the hope that it will meet the target the investor has set in their mind, even if the investment is not worth that amount. 
  • People value securities using specific rules of thumb based on metrics and benchmarks. However, this bias may occur when people blindly use these metrics and measures and ignore any evidence to see if the value of the investment is more or less. 

These benchmarks are somewhat harmful and can be detrimental to investors as they increase their risk while potentially leading to them missing out on good opportunities. Thus, it is always advisable for the investor to eliminate such anchors and make objective decisions.

This requires the investor to rely more on careful market conditions and securities research rather than let emotions cloud their judgments.

Example

An investor buys a security XYZ at $50. The stock market then sees a fall due to economic difficulties, as the share falls to $35. The investor, however, is more likely to hold on to the share even if the claim isn't worth $50 anymore.

This is because the investor created a benchmark of $50 while buying the investment and thus would be reluctant to sell the asset for any value below it. 

However, in such a situation, even though he should get rid of the investment, he continues to hold on to it, thereby increasing his risk.

The investor might wait a year for the share to increase to the $50 price. Instead of waiting a long time for the share price to return to the $50 fee, it would have been better for the investor to sell the share, invest in another security, and get higher returns.

Causes of Anchoring bias

It has often been shown that people can create these frameworks relating to values that aren't remotely related to the task. 

For example, in a study, people were asked for the last two digits of their social security number. They were then shown various items of computer equipment, wine, chocolates, etc., and were asked whether they would be willing to pay the amount formed by the last two digits of their social security number.

They were then asked for the maximum amount they would be willing to pay for such items. For example, it was seen that people who had a high social security number, say 84, were willing to pay a much higher price than someone with a lower social security number, say 11. 

This is because even though the social security number was a completely random value in this case, as it was asked in the beginning, people created a mental framework using that random number. All subsequent decisions were related to that framework. 

There have been a lot of theories that have tried to explain this phenomenon. However, there has never been a consensus on the exact cause of this phenomenon. 

It is, however, believed by many that in this phenomenon, multiple causes at play combine to give rise to this phenomenon. 

Some of these causes are as follows:

Anchoring and adjustment

This phenomenon was first explained by Amos Tversky and Daniel Kahneman in a 1974 paper called "Judgment under Uncertainty: Heuristics and Biases." In the paper, Tversky and Kahneman hypothesized that when people try to make estimates or predictions, they begin with some initial value or starting point and then adjust from there. 

However, the bias occurs as the adjustments are primarily insufficient because they arise at an answer very close to the original answer itself.

To back this up, they ran a study where people guessed the answers to mathematical equations in a short time. Within five seconds, the subjects were asked to estimate the product of 8 x 7 x 6 x 5 x 4 x 3 x 2 x 1 while another group was given the same sequence, but in reverse: 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8. 

The median estimate for the first problem was 2,250, while the median for the second was 512 (the correct answer is 40,320). It was theorized that the difference occurs as they can only calculate up until a value says 8 x 7 x 6, which creates an anchor. 

They then try to adjust to get away from the anchor. However, they cannot make a big enough adjustment and get an answer closer to the framework set. 

While investing, too, people may try to adjust the values after anchoring. However, these adjustments too often reflect the original bias of the benchmarks.

Selective accessibility

Another explanation for this bias is a phenomenon known as selective accessibility, which is derived from a theory called "confirmatory hypothesis testing."

In a nutshell, selective accessibility suggests that when provided an anchor, the subject will assess whether or not the benchmark given is a good answer. 

Assuming it isn't, the judge moves on to another guess, but not before looking at all of the anchor's relevant features and looking for ways the new answer is comparable to the anchor while evaluating it, resulting in this bias.

For example, in an online study, it was shown that the previous ratings of the general masses affected the decisions of subsequent ratings too. 

While evaluating a business idea, if the previous ratings were displayed, people would often incorporate them while making their own decisions. 

This resulted in a lower variance in the subjects' ratings, as the new ratings were closer to the rating provided, which created a benchmark in the minds of the latest topics.

Attitude

A shift in attitude and mood is another emerging explanation for this phenomenon. 

According to this hypothesis, when someone builds such a framework, it alters their attitudes to be more receptive to the framework's specific features, biasing future responses to have similar characteristics to the benchmark set.

Even things like a person's mood and personality can lead to anchoring. For example, it has been seen in recent studies that people in more positive moods are less prone to this bias than those in sadder moods. This is because positive attitudes lead to more systematic processing of information.

Similarly, things like overconfidence may lead to this bias. People who show overconfidence are more prone to put a higher emphasis on their original assessments. 

It was even found that people with high levels of experience in their fields, people with higher cognitive abilities, and people who were experts in their fields were also prone to this phenomenon. 

For example, in an experiment similar to poker with people of differing academic achievement, it has been found that this phenomenon is not related to education level. 

Avoiding Anchoring Bias

Altogether, avoiding this bias is impossible, given that it happens subconsciously. Moreover, studies show that even experts in their fields and people with high intellects are prone to this bias.

Ideas that work better with other cognitive biases, like taking time with one's decisions, also don't work with this bias, considering it results in the information consistent with the benchmark within our minds being activated. 

One strategy that works is to consider why the anchor is inappropriate before making decisions. For example, according to a study, car salespeople were asked whether the car's resale price was right and, if not, to provide a better one.

In normal circumstances, the original price would have created a benchmark in the minds of the salespeople and would have impacted their estimates. But instead, half the salespeople were asked to come up with arguments against the price.

It was found that these salesmen were less prone to bias compared to those who didn't make such arguments. Apart from this, it helps to be more aware of the bias so that it becomes somewhat easier to spot situations in which one might be prone.

It is also possible to use this bias to one's advantage. For example, while negotiating, if one is aware of the effects and makes the first offer, it allows them to drive the negotiation.

Anchoring Bias FAQs

Researched and authored by Soumil De | LinkedIn

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