What's Anchoring bias?
Anchoring bias occurs when people consider or rely too heavily on the first piece of information they receive about a situation when making a decision.
Now all future decisions or estimates are now taken on the basis of this initial assumption or information.
Anchoring is a case of suggestion. This is the word we use when someone causes us to see, hear, or feel something by merely bringing it to mind.
This initial information not only influences people to make wrong decisions but due to this they also fail to adjust their estimates or decisions based on new or contradictory information.
When we change our decisions on the basis of new information it’s called Adjustment. But still our adjustment must be close to our initial information.
While anchoring is a cognitive bias where we take decisions on the basis of fact whereas adjustment is a conscious decision a person takes.
Ebbinghaus illusion:
The circle at the center of the two sets are identical in size, but the one contrasted with the smaller circles seems larger. Read more
Real life example:
Real estate agent manipulation:
If you consider how much you should pay for a house of 1500 sq ft, and you get an answer of 30 lakh. Now this is the anchor has been set in your mind, and if you start looking for the house similar to previous one but selling at 20 lakh then you underestimate this house and will consider it inferior whereas if find another house with the price of 40 lakh then even though it was not very different than initial house but still you will overestimate it.
How child manipulates you:
Infants or small child uses this bias unknowingly to us, “ when u take them outdoors, they start asking you anything that they see on outside or on the hands of others whether it is cheap or costly like they may ask you to buy a toy, ice cream, etc and when their demands starts increasing they starts crying. In order to get rid from this situation you end up buying something which is a better replacement for their demands. Like if he or she asks for ice cream and you think ice cream is not good for the health of an infant then maybe you end up buying some chocolate for him or her, which is also not for teeth but far better than ice cream.
Anchoring and adjustment in stock market
Here are a few real case studies and examples of anchoring bias in the stock market:
P/e ratio:
We use these anchoring and adjustment shortcuts when we begin with proper anchors and adjust from them properly.
Many investors begin the process of stock selection by looking at the Price to Earning ratio of a company, comparing it with the PE of the same industry and setting it as an anchor for stock selection. But we could commit anchoring and adjustment errors when we begin with faulty anchors and adjust them improperly.
Assume you have selected a stock with PE of 25 and the PE of the same industry is 30, you believe that stock is undervalued and bought that stock. Whereas in reality what if the fundamentals of the company are not good or what if the whole industry is inflated in a bubble.
52-Week Highs and Lows:
Amateur investors tend to be anchored to a 52 week stock price or low when making decisions.
If a stock approaches its 52-week high, investors may anchor to that high price and be hesitant to buy, fearing a potential downturn. Conversely, if a stock approaches its 52-week low, investors may anchor to that low price and view it as a buying opportunity, regardless of the stock’s intrinsic value or future prospects.
Initial Public Offerings (IPOs):
When a company goes public with its IPO, the offering price sets an anchor for investors. If the IPO is priced too high, investors might still be anchored to that initial price, even if the stock’s value decreases after trading begins. This can lead to overvaluation and subsequent losses for investors who anchored to the IPO price.
Price Targets by Analysts:
Analysts often provide price targets for stocks based on their analysis. Investors may anchor to these price targets and make decisions based on them, even if the market conditions change or new information becomes available. If the stock price deviates significantly from the analyst’s target, investors may be slow to adjust their expectations, leading to missed opportunities or losses.
These examples illustrate how anchoring bias can influence investor behaviour and decision-making in the stock market, often leading to suboptimal outcomes. Recognizing and mitigating anchoring bias is crucial for investors to make informed decisions based on current information and market conditions rather than relying solely on past anchors.
