The world of finance involves working with numbers and estimates at all levels. Whether it is reading reports, or conducting in depth research on a business, people rely on estimates and predictions to eventually invest their money. But what if we told you that your estimates might be off by more than a margin of 50% thanks to a very discreet cognitive bias? Cognitive biases like base rate fallacy, ambiguity effect and others play a significant role in shaping the way investors perceive and act upon information. Among these biases, anchoring bias stands out as a powerful force, influencing investors' judgments and leading to potentially flawed investment decisions. Stemming from the tendency to rely too heavily on the first piece of information encountered, anchoring bias can lead investors astray, affecting their assessment of financial opportunities and risks.
Understanding Anchoring Bias
To lead with a simple example, the Anchoring bias works well in the world of discounts. Supposedly, an item is originally priced at Rs 50, but it is sold at 50% discount after being priced at Rs 100, then the latter case would make for a more attractive purchase, instead of the initial Rs 50 selling price. This phenomenon is rampant in the food delivery industry, multi level marketing and retail stores.
Anchoring bias was first explained by psychologists Amos Tversky and Daniel Kahneman through a fascinating experiment on the priming effect. When participants were asked a question about how many percent of UN members are African nations, after spinning a random wheel of fortune rigged to stop at 65 or 10, the results were astounding. Even though the wheel of fortune did not have any bearing on the real stats, not even a non-rigged one, the participants whose wheel stopped at 10, estimated the answer to be 25% and whose wheel stopped at 65, estimated the answer to be 45%.
To state simply, anchoring bias represents the tendency for individuals to rely heavily on the first piece of information they receive when making decisions.
In the context of investing, this bias can manifest when investors base their valuation of assets, such as stocks or properties, on initial values, subsequently failing to reassess their worth based on market dynamics or intrinsic value.
When it comes to financial advisors, some advisors who come with a background of a particular industry or company might be biassed towards investment in that particular sector. This is because their first experience and gains might act as an “anchor” through which they make decisions. Similarly, a single good experience with a particular stock might make it seem more attractive for future investments which might be a recipe for disaster given the ever-changing economic, geopolitical and market conditions.
Kahneman, in his seminal work "Thinking, Fast and Slow," explains anchoring bias as a cognitive shortcut that investors often unconsciously employ to simplify the decision-making process. He stresses the significance of understanding this bias and its implications, especially when it comes to investing in the financial markets. As he aptly puts it, "Anchoring is a powerful force that operates in a variety of situations and helps to explain why people do not adjust sufficiently from their initial starting points.”
One more invigorating fact that sets apart the anchoring bias from other cognitive biases is the fact that it can be measured through something called as the Anchoring Index. By calculating the difference between various estimates, investors can arrive at the level of bias that happens in a particular decision. This Anchoring Index can be a tool to avoid faulty decision making influenced by this cognitive bias.
Application of Anchoring Bias in Investing
The application of this bias in investing can lead to several detrimental outcomes. For instance, consider a scenario where an investor is presented with a stock's initial price that is significantly lower than its intrinsic value. This lower price becomes the anchor, and the investor may be hesitant to sell the stock even when the market value far exceeds the initial price, leading to missed opportunities for profit. On the flip side, an investor might anchor their valuation to a previous high value of a stock, leading them to overlook the stock's current downward trend, resulting in substantial losses.
One notable example of anchoring bias impacting the investing world occurred during the dot-com bubble of the late 1990s. Many investors anchored their valuation of tech stocks to the skyrocketing prices, failing to consider the companies' actual earnings potential. Consequently, when the bubble burst, investors suffered substantial financial losses, revealing the perils of anchoring bias in a volatile market.
To talk about another recent example, take the case of financial influencers in India. If an investor hears about the positive prospect of a stock from an influencer’s channel, they might miss out on doing their own quantitative research and anchor their decision to the first opinion that they come across. This can yield detrimental results as the market changes its trajectory.
Moreover, real estate investment and the infrastructure industry also fall prey to anchoring bias, where sellers might anchor their property prices to previously high market rates, even when the current market demands lower prices. Similarly, buyers might anchor their offers to the lower prices prevalent during a market downturn, failing to perceive the property's actual value during an upturn.
Overcoming Anchoring Bias in Investment Decisions
To counteract the detrimental effects of anchoring bias, investors must cultivate a disciplined approach to decision-making. It is imperative to undertake comprehensive research, considering multiple sources of information and expert opinions to form a well-rounded view of an asset's true value. Moreover, establishing clear investment criteria and predefined exit strategies can help prevent the undue influence of an arbitrary anchor.
Noted investor Warren Buffett, known for his shrewd investments, emphasises the importance of independent thinking and rational analysis in the face of anchoring bias. He advocates for a thorough understanding of a company's intrinsic value, advising investors to anchor their valuations to this fundamental metric rather than ephemeral market fluctuations.
Additionally, fostering a culture of open discussion and diverse perspectives within investment teams and among advisors can help mitigate the influence of anchoring bias. By encouraging constructive dissent and critical evaluation of investment decisions, teams can collectively challenge preconceived notions and avoid the pitfalls of biassed judgement.
The Gist
Anchoring bias remains a pervasive force in investments and daily life, significantly shaping investors' decisions and potentially leading to substantial financial repercussions. By understanding the psychology behind this bias, investors can adopt strategies to mitigate its impact and make more informed and rational investment decisions. As the financial markets continue to evolve, the ability to navigate cognitive biases, including anchoring bias, will prove to be a crucial skill for investors striving to achieve sustainable success. As Kahneman aptly summarises, "Anchoring is a cognitive trap that can skew judgement and lead to significant financial missteps, but with awareness and careful analysis, investors can navigate this bias and make sound decisions for long-term financial prosperity."
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