The Anchoring Effect, and why it stops us from setting sail

Imagine you’re in the market for a new house, and you come across a house that you particularly like. However, after a chat with the real estate agent, you’re taken aback to find that the asking price is a lofty $2,000,000.

As you really want the house, you put in a low-ball offer of $1,500,000, and start to negotiate. After a week of back and forth, you settle on a final price of $1,800,000, which is 10% below the asking price.

You feel happy because you’ve reduced the price by 10%, but what if the house was overpriced in the first place?

This is the anchoring effect. It occurs when an initial price becomes an anchor that is used in all further negotiations. Once the anchor is set, there is a bias for interpreting information relative to that anchor. The effect distorts our view of value and can cause us to overpay.

Mahatma Ghandi’s age

In 1997, researchers Strack and Mussweiler conducted an experiment on the anchoring effect, whereby two separate groups were asked the following questions.

The first group was asked, ‘Did Mahatma Ghandi die before or after age 9?’ After responses were given, the group was then asked, ‘Assuming he died after age 9, what age did he die?’ The group gave an average answer of 50.

The second group was asked, ‘Did Mahatma Ghandi die before or after age 140?’ After providing responses, they were then asked, ‘Assuming he died before age 140, what age did he die?’ The second group gave a much higher average answer of 67.

The experiment was repeated several times with similar results.

The experiment showed that the age used in the initial question, became an anchor. A low age on the initial question resulted in a lower average age estimate, and a high age on the initial question resulted in a higher average age estimate.

Negotiations

Anchors are used extensively in negotiations. When we negotiate salaries, anchors are used as starting points. When buying an item like a leather jacket, the item’s Recommended Retail Price is an anchor. If we receive 30% off the RRP we assume we have a ‘bargain’, but the reality could be that the jacket is still overpriced, even with the discount.

When we negotiate the price of a car or a house, the initial price becomes the anchor that influences where the final price settles.

Psychologist Daniel Kahneman in his book Thinking Fast and Slow, suggests that a way to counteract the anchoring effect, is to think about what the minimum amount would be for the seller to accept. In addition, one could think through what the cost would be to the opponent if there was a failure to reach an agreement.

Investing

In investing, anchors are used all the time.

For example, if someone buys a stock only to watch the price plummet, they may get on bended knee and say the ‘Trader’s Prayer’, which is, ‘Dear God, please get me back to even and I promise I’ll get out’. In this example, the stock’s purchase price is the anchor, however such a thought process can be costly for two reasons.

Firstly, the market doesn’t know (or care) what your purchase price is. Hence, if your stock or ETF returns back to its original purchase price, it may just as easily keep going to greater heights, thus depriving you of potential gains.

Secondly, if the company you’ve bought into has tanked for valid reasons (such as it’s going broke), then the best course of action may be to get out while you can.

Another way anchoring affects an investor is when we think a stock is cheap because it’s fallen by 20% in the past month. This is using the original price as an anchor. However, the stock still could be expensive when comparing it to its underlying intrinsic value.

Whatever the scenario, anchors fool us, and distort our view of value. When we think of selling stocks or ETFs, the purchase price shouldn’t be a consideration unless it’s for tax purposes. An investor should be focused on what the investment is likely to do in the future, rather than where its price has been in the past.

Casting off the anchor

The anchoring effect is a powerful bias, but it can be beaten. Here are three ways:

1. Awareness. As this is a subconscious bias, most people are not aware of it. We should try to become aware of where anchors are used in our day-to-day lives.
2. Forget your purchase price. When considering the sale of a stock or ETF, do not think in terms of the purchase price, but rather the investment’s underlying intrinsic value.
3. Always be aware of long-term trends. Know that if history is a guide, the long-term trend for the stock market is always up. Owning broad-based ETFs should see your investments rise in value over time.