Let's start with a real-life example :
- You are looking to buy a home. The upper limit of your budget is $500,000.
- You call up a broker. He takes you to a home and tells you the price tag of $750,000.
- You liked the house, but the price is much above your budget, and you know that the house is not worth that price.
- Now, it is time for negotiations. The negotiations start by adjusting the price tag of $750,000. That is, the initial quoted price becomes the anchor, from which adjustments are made.
- You negotiate and manage to bring the price down to $600,000. You're happy about your negotiation skills (Honey, I've brought down the price by 20%!).
- But your wife scolds you - the price is 20% above your budget's upper limit! The anchor has impacted your purchase price. Now, tell me who was the better negotiator?
In 1974, Nobel laureate Daniel Kahneman and his friend Amos Tversky proposed a theory they called "anchoring-and-adjustment heuristic."
Here is how Wikipedia defines this bias:
Anchoring or focalism is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered (the "anchor") when making decisions. During decision making, anchoring occurs when individuals use an initial piece of information to make subsequent judgments. Once an anchor is set, other judgments are made by adjusting away from that anchor, and there is a bias toward interpreting other information around the anchor.
In many situations, people make estimates by starting from an initial value (anchor) that is adjusted to yield the final answer. The duo also observed that the adjustments are insufficient and are biased towards the anchor value.
Now that we have understood the theory, let's look at some of the real-life examples:
First impressions: When we meet someone, the first impressions created form the basis on which we judge the person in the future. Further changes in the judgments are done by adjusting the earlier impressions.
Negotiations for sales: Salesmen start by quoting high prices for the stuff, which forms the anchor from where we bargain (adjust) to arrive at the final price.
Giving favors: In order to get a favor from someone, it is said to be a good strategy to ask first for a big favor (which we don't intend to receive), which gets rejected, and then follow up by asking a smaller favor which is likely to get accepted. We can connect this with what Robert Cialdini wrote in his book "Influence." The second smaller request is viewed as a concession, and hence is likely to get accepted.
Investing: We can witness this bias in both buying and selling decisions. While thinking about buying stocks, investors seem to have 52-week low, a target multiple or a target price in mind above which they refuse to buy. Say, the price of the stock is currently $125, and the investor does not want to buy it above $100. The $100 figure, by the way, does not mean anything fundamentally - it is just that the investor is anchored to the number without any real reason. While making the sale decision, investors seem to wait for their purchase price to be exceeded (if the stock is now quoting at a loss), or return target to be met, or 52-week high or target multiples to be reached. Anything other than intrinsic value should be irrelevant for investment decision making. It so happens that, when we estimate intrinsic values, we tend to get biased by the current market price of stocks. Further, it is a common practice among sell-side analysts to get anchored to the consensus earnings numbers and then adjust their own estimates around that number.
How to avoid this bias
- As is the case with any bias, we should first be able to recognize the presence of the bias.
- Every time an anchor number is thrown at us, ensure that we are not getting influenced by the anchor. Understand that the anchor number is irrelevant.
- In investing, the purchase and sale decision should be taken based on the intrinsic value as of the date of analysis. After buying the stock, purchase price is irrelevant. We should also understand that the 52-week high cannot be assumed to be intrinsic value. Also, take care to avoid the bias from current market price, while computing intrinsic value - the best strategy is to not look at market prices until you compute intrinsic value.
This article was originally published in my blog My Investing Life.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.