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Anchoring Bias

The anchoring bias occurs when we make a decision or evaluation based on the first piece of information received. Our first impression acts as an anchor or reference point to which all subsequent and related information is compared. If the anchor contains incomplete or irrelevant information we can end up making a bad decision. [1]

During normal decision making, individuals anchor, or overly rely, on specific information or a specific value and then adjust to that value to account for other elements of the circumstance. Usually once the anchor is set, there is a bias toward that value.[2]


Examples of Anchoring Bias[3]
An example is when a consumer judges the relative value of a product or service from a company on the basis of the cost in some previous period of time. Or, an investor may judge that a stock price is overvalued or undervalued based on that stock's previous high share price.


Factors that Influence Anchoring[4]

  • Mood: A wide range of research has linked sad or depressed moods with more extensive and accurate evaluation of problems. As a result of this, earlier studies hypothesized that people with more depressed moods would tend to use anchoring less than those with happier moods. However, more recent studies have shown the opposite effect: sad people are more likely to use anchoring than people with happy or neutral mood.
  • Experience: Early research found that experts (those with high knowledge, experience, or expertise in some field) were more resistant to the anchoring effect. Since then, however, numerous studies have demonstrated that while experience can sometimes reduce the effect, even experts are susceptible to anchoring. In a study concerning the effects of anchoring on judicial decisions, researchers found that even experienced legal professionals were affected by anchoring. This remained true even when the anchors provided were arbitrary and unrelated to the case in question.
  • Personality: Research has correlated susceptibility to anchoring with most of the Big Five personality traits. People high in agreeableness and conscientiousness are more likely to be affected by anchoring, while those high in extroversion are less likely to be affected. Another study found that those high in openness to new experiences were more susceptible to the anchoring effect.
  • Cognitive Ability: The impact of cognitive ability on anchoring is contested. A recent study on willingness to pay for consumer goods found that anchoring decreased in those with greater cognitive ability, though it did not disappear. Another study, however, found that cognitive ability had no significant effect on how likely people were to use anchoring.


Consequences of Anchoring[5]
An anchoring bias can cause a financial market participant, such as a financial analyst or investor, to reject a correct decision (buy an undervalued investment, sell an overvalued investment) or accept an incorrect decision (ignore an undervalued investment or buy/hold an overvalued investment). The anchoring bias can be present anywhere in the decision-making process, from key forecast inputs (e.g., sales volumes, commodity prices) to final output (e.g., cash flow, securities price.) Historical values, such as acquisition prices or high water marks, are common anchors. This holds for values necessary to accomplish a certain objective, such as achieving a target return or generating a particular amount of net proceeds. These values are unrelated to market pricing and cause market participants to reject rational decisions. Anchoring can be present with relative metrics, such as valuation multiples. A market participant using a rule-of-thumb valuation multiple to evaluate securities prices, such as X-times-EBITDA or Y-times-free cash flow, is demonstrating anchoring when they ignore evidence that one security has a greater potential for earnings growth.


Understanding Anchoring - Takeaways for Decision- Makers<ref>Understanding Anchoring - Takeaways for decision-makers CognitiveLode

  • If you are to use anchors, be aware of your target audience. Anchoring effects are weaker for individuals with higher cognitive ability (Bergman et al., 2010) and those with experience buying the product you’re selling (Alevy et al., 2011).
  • Don’t set your anchor price too high, or the natural inclination to anchor other choices against this product will greatly diminish. Keep it realistic and relatively in the realm of what else you’re selling, basically.
  • Think carefully about how you structure your product range and prices. People will anchor whether you intend for them to do so, or not.


See Also

Cognitive Bias
Confirmation Bias


References

  1. Definition of Anchoring Bias Psychology Glossary - alleydog.com
  2. What is Anchoring Bias? sciencedaily.com
  3. Examples of Anchoring Bias Business Directory
  4. Factors that Influence Anchoring Wikipedia
  5. Consequences of Anchoring Investopedia


Further Reading