“Investors of XYZ shares had to incur losses as they took a wrong decision by deciding to invest more due to the anchor. The lack of cognitive thinking and the anchoring bias of the investors are definitely a shortfall for them in the competitive world full of smart investors.” I am sure this piece of a headline is quite baffling to understand as we are unfamiliar with the term “Anchoring”. When you are done reading this article, that won’t be the case.
It’s important to understand a little bit of psychology before we delve into the finance and investing part of Anchoring. Though we human beings are different from other living beings due to the fact that Science claims us to have the sixth sense and we have a complex thought structure compared to other living beings but do we all think the same way? No. And why is the world the way it is today? It is all due to the different thought processes we have and the decisions we take. We all develop intelligence and knowledge throughout our life, also known as cognitive ability. This Cognitive ability however is not perfectly utilized by everyone and is subject to various biases. These biases play a key role in all the decisions we take in our lives.
One such bias that makes our decisions flawed is Anchoring Bias. The tendency to make a decision based on the first piece of information or clues you get without giving it a deep thought is known as Anchoring. And that piece of information that you depend on is known as the Anchor for your decision. Let’s understand this through a daily-life example. Suppose you go shopping and find a shirt which is priced at Rs.1500 and you decide not to buy the same since it’s expensive. But then you find a shirt which is priced at Rs.1000 and you buy the same since it’s cheaper than the first shirt you came across without giving it any second thought. Later you come to know that there was another shirt which was priced at Rs.800, but your biased decision based on the first piece of information you got makes you spend more for the same article. You have created a benchmark value in your mind before analyzing it properly. This is known as Anchoring Bias and the price of the First Shirt is the Anchor of that decision.
Though this sounds like a key concept in psychology, it holds a great deal of significance in Investing. Anchoring Bias is an integral part of Behavioural Finance as it studies how the emotional quotient of the investor and other outside factors affect the decision of the investor/financial analysts. The Investors and the financial analysts tend to have an anchoring bias in the investment decisions they take and the evaluations they make due to the psychological benchmark they have in their mind for that particular investment in the market. We are all taught to believe in finance and economics that investors are rational where it is actually not the case. Investors are normal, not rational, and that is the reason behind their flawed investing decisions. Anchoring and Adjustment Heuristic (the technical Jargon) was first theorized and explained by Amos Tversky and Daniel Kahneman through various sets of experiments.
Now taking an example in the investing realm to give you an actual outlook of that bias, let’s assume that an investor while evaluating the stock prices notices the initial price to be Rs.100 and buys the stock at that price. Now he will set this as a benchmark for all the trading activities of that particular share and this becomes the Anchor of his decision.
This irrational financial decision of the investor makes him incur losses and he doesn’t earn the targeted net proceeds due to his lack of deep analysis. Sometimes the investor tends to buy an investment that is undervalued and at times sells an over-valued investment due to the effects of Anchoring Bias. The usual anchors in the market include the Historical Price of the stock, the acquisition price, and the purchase price at the time of evaluation by the investor. According to Tversky and Kahneman, this bias is caused majorly due to the following reasons. The investor’s and analysts’ mood during investing, the experience that they had before, their cognitive ability, and their personality traits.
When it comes to the mood of the investor, a happy mood might affect the investor to consider other negative aspects the investment could carry along with it and are taken away by the anchor. An investor in a sad or depressed mood lacks the motivation to research the relevant factors and go in for the first piece of information they come across. The experience of the investor in the past where he/she might have earned a good amount of net proceeds due to anchoring effects tends to make the same mistake again believing they will earn a good share this time as well. The investors with better cognitive ability have low chances of susceptibility to Anchoring Bias in their decisions.
The personality traits of a person are classified as the Big Five Personality Traits. A person who falls under the category of agreeableness and conscientiousness has high chances of committing an anchoring bias in the decision he takes whereas a person under the category of neuroticism and extraversion mostly put their cognitive ability to its fullest potential when it comes to investing.
While Anchoring Bias is considered to be a mistake committed by the normal investors in the market, even the investing giants and expert analysts are victims of this anchoring and adjustment heuristic. Though the ways to correct the errors of Anchoring are very few, it’s always possible to avoid Anchoring during an investment. The few ways through which one can avoid Anchoring is by asking questions to themselves regarding their decision twice or thrice, and to create a deep analysis of the prices throughout the history and then come to a conclusion and delay your decision for better results.
I hope now the anchor given in the first paragraph did not lead you to a biased decision like the usual Anchors in your daily life.
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Raised in the land of idly,living in the land of kulcha,Meena is currently pursuing B.Com(Hons.) and multi-tasking at SRCC.She has a head for realism,heart full of candour and a hand to pen down her boundless thoughts and another to hold the coffee mug(always).Perky enough,she exerts to explore all her potentiality,ranging from music to research.