10
Information Processing Bias #2: Anchoring Bias

To reach a port we must sail, sometimes with the wind, and sometimes against it. But we must not drift or lie at anchor.

Oliver Wendell Holmes

Bias Description

Bias Name: Anchoring

Bias Type: Cognitive

Subtype: Information processing

General Description

When required to estimate a value with unknown magnitude, people generally begin by envisioning some initial, default number—an “anchor”—which they then adjust up or down to reflect subsequent information and analysis. The anchor, once fine-tuned and reassessed, matures into a final estimate. Numerous studies demonstrate that regardless of how the initial anchors were chosen, people tend to adjust their anchors insufficiently and produce end approximations that are, consequently, biased. People are generally better at estimating relative comparisons rather than absolute figures, which this example illustrates.

Suppose you are asked whether the population of Canada is greater than or less than 20 million. Obviously, you will answer either above 20 million or below 20 million. If you were then asked to guess an absolute population value, your estimate would probably fall somewhere near 20 million, because you are likely subject to anchoring by your previous response.

Example of Anchoring and Bias

This chapter reviews one miniature case study and provides an accompanying analysis and interpretation that will demonstrate investor potential for Anchoring Bias.

Miniature Case Study: Anchoring Bias

Case Presentation

Suppose Alice owns stock in Corporation ABC. She is a fairly astute investor and has recently discovered some new information about ABC. Her task is to evaluate this information for the purpose of deciding whether she should increase, decrease, or simply maintain her holdings in ABC. Alice bought ABC two years ago at $12, and the stock is now at $15. Several months ago, ABC reached $20 after a surprise announcement of higher-than-expected earnings, at which time Alice contemplated selling the stock but did not. Unfortunately, ABC then dropped to $15 after executives were accused of faulty accounting practices. Today, Alice feels as though she has “lost” 25 percent of the stock's value, and she would prefer to wait and sell her shares in ABC once it returns to its recent $20 high.

Alice has a background in accounting, and she does some research that leads her to conclude that ABC's methods are indeed faulty, but not extremely so. However, Alice cannot entirely gauge the depth of the problem and realizes that holding ABC contains risk, but ABC is also a viable corporate entity with good prospects. Alice must make a decision. On one hand, she has confirmed that ABC does have an accounting problem, and she is unsure of how severe the problem might become. On the other hand, the company has a solid business, and Alice wants to recoup the 25 percent that she feels she lost. What should Alice do?

Analysis

Most investors have been confronted with situations similar to this one. They decide to invest in a stock; the stock goes up and then declines. Investors become conflicted and must evaluate the situation to determine whether to hold on to the stock. A rational investor would examine the company's financial situation; make an objective assessment of its business fundamentals; and then decide to buy, hold, or sell the shares. Conversely, some irrational investors—even after going through the trouble of performing the aforementioned rational analysis—permit cognitive errors to cloud their judgment. Alice, for example, may irrationally disregard the results of her research and “anchor” herself to the $20 figure, refusing to sell unless ABC once again achieves that price. This type of response reflects an irrational behavioral bias and should be avoided.

Implications for Investors

A wide variety of investor behaviors can indicate susceptibility to Anchoring Bias. Box 10.1 highlights some important examples of which investors and advisors should be aware.

Am I Subject to Anchoring Bias?

In this section, we outline a hypothetical decision-making problem and discuss how and why various reactions to this problem may or may not indicate susceptibility to Anchoring Bias.

Anchoring Bias Test

Scenario: Suppose you have decided to sell your house and downsize by acquiring a townhouse that you have been eyeing for several years. You do not feel extreme urgency in selling your house, but the associated taxes are eating into your monthly cash flow, and you want to unload the property as soon as possible. Your real estate agent, whom you have known for many years, prices your home at $900,000—you are shocked. You paid $250,000 for the home only 15 years ago, and the $900,000 figure is almost too thrilling to believe. You place the house on the market and wait a few months, but you don't receive any nibbles. One day, your real estate agent calls, suggesting that the two of you meet right away. When he arrives, he tells you that TechGrowth, a company that moved into town eight years ago in conjunction with its much-publicized initial public offering (IPO), has just declared Chapter 11 bankruptcy. Now, 7,500 people are out of work. Your agent has been in meetings all week with his colleagues, and together they estimate that local real estate prices have taken a hit of about 10 percent across the board. Your agent tells you that you must decide the price at which you want to list your home, based on this new information. You tell him that you will think it over and get back to him shortly.

Question: Assume your house is at the mean in terms of quality and salability. What is your likeliest course of action?

  1. You decide to keep your home on the market for $900,000.
  2. You decide to lower your price by 5 percent, and ask $855,000.
  3. You decide to lower your price by 10 percent, and ask $810,000.
  4. You decide to lower your price to $800,000 because you want to be sure that you will get a bid on the house.

Test Results Analysis

A tendency toward either of the first two responses probably indicates susceptibility of the subject to Anchoring Bias. Remember that real estate prices here have declined 10 percent. If the subject wants to sell his or her home, he or she clearly must lower the price by 10 percent. Resistance to an adequate adjustment in price can stem, however, from being anchored to the $900,000 figure. Anchoring Bias impairs the subject's ability to incorporate updated information. This behavior can have significant impact in the investment arena and should be counseled extensively.

Investment Advice

Before delving into specific strategies for dealing with Anchoring, it's important and, perhaps, uplifting to note that you can actually exploit this bias to your advantage. Understanding Anchoring can, for example, be a powerful asset when negotiating. Many negotiation experts suggest that the participants communicate radically strict initial positions, arguing that an opponent subject to anchoring can be influenced even when the anchor values are extreme. If one party begins a negotiation by offering a given price or condition, then the other party's subsequent counteroffer will likely reflect that anchor. So, when negotiating, it is wise to start with an offer much less generous than reflects your actual position (beware, however, of overdoing this). When presenting someone with a set of options, state first the options that you would most prefer that the other party select. Conversely, if a rival negotiator makes a first bid, do not assume that this number closely approximates a potential final price.

From the investment perspective, awareness is the best countermeasure to Anchoring Bias. Investors should ask themselves: “Am I analyzing the situation rationally, or am I holding out to attain an anchored price?” When making forecasts about the direction or magnitude of markets or individual securities, ask yourself: “Is my estimate rational, or am I anchored to last year's performance figures?” Taking these sorts of actions will undoubtedly root out any Anchoring Bias that might take hold during asset sales or asset reallocation.

Finally, when considering a recommendation by a securities analyst, delve further into the research and ask yourself: “Is this analyst anchored to some previous estimate, or is the analyst putting forth an objective rational response to a change in a company's business fundamentals?” Investment professionals are not immune to the effects of Anchoring Bias. In fact, there is an investment strategy that can leverage this behavior, which will be discussed in the “bonus discussion.”

Bonus Discussion: Investment Strategies That Leverage Anchoring Bias

An awareness of the mechanics of anchoring can actually serve as a fundamental tenet of a successful investment strategy. Some finance professionals leverage Anchoring Bias by observing patterns in securities analyst earnings upgrades (downgrades) on various stocks and then purchasing (selling) the stocks in response. The behavioral aspect of this strategy is that it takes advantage of the tendency exhibited by securities analysts to underestimate, both positively and negatively, the magnitudes of earnings fluctuations due to Anchoring Bias.

As previously noted, when issuing upgrades and downgrades, analysts anchor on their initial estimates, which can be exploited. If an analyst is anchored to an earnings estimate and earnings are rising, this is an opportunity for investors to win, as it is likely that the analyst is underestimating the magnitude of the earnings upgrades. Conversely, if the analyst is anchored to an earnings estimate and earnings are falling, this is an opportunity to lose, so it's best to sell immediately on the first earnings downgrade, as it is likely that the analyst is underestimating the magnitude of the earnings downgrades.

In sum, we have learned that we need to be aware of the tendency toward Anchoring Bias and the ill effects it can have on our portfolios. At the same time, we can leverage it to our advantage in certain cases, such as in negotiation and in the investment strategy just reviewed.

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