Humans employ mental shortcuts in everyday life to help process information and make quick decisions. However, they can result in poor financial choices at times.
Some of these bad results are due to ‘anchoring bias’, which can impair the rational and logical thinking of a consumer.
This cognitive bias causes the human brain to place an undue emphasis on first impressions or numbers to form subsequent thoughts or choices. To put it another way, such initial information “anchors” the decisions made in the future.
Anchoring bias can be a big problem for traders and investors, as it can cause them to make buying and selling decisions by relying too heavily on a single piece of information, irrespective of whether it needs to be corrected or updated.
In this blog post, we’ll learn about anchoring bias in detail and provide techniques to prevent it from influencing your trades.
What is Anchoring Bias?
Anchoring Bias is a cognitive bias identified by behavioral finance, in which people over-rely on previously learned knowledge that may or may not be relevant when making a decision. They then utilize that information as an anchor for decision-making in the future, even when presented with new information that conflicts with the anchor.
According to this bias, people often consider data from the reference point of the benchmark when making decisions rather than evaluating more recent information with objectivity.
In behavioral finance studies, anchoring – also referred to as the anchoring effect – looks at how emotions and other external factors affect economic choices.
For example, if you see a cloth that costs $1,300 and then see another one that costs $200, you are prone to perceive the second cloth as cheap because the first cloth is usually considered as a benchmark, and people see the second cloth from the reference of the first. On the contrary, you wouldn’t consider the second cloth to be cheap if you had only looked at its $200 price. The anchor – the first piece of information that you viewed – unduly impacted your decision.
Understanding Anchoring Bias
Anchoring bias falls under the field of behavioral finance, which examines how emotions affect the decision-making process and can cause someone to make irrational decisions.
It is a cognitive bias that occurs when someone establishes a standard because they give one piece of information disproportionate weight while making decisions. A person who suffers from this bias bases all of their subsequent decisions on the framework they constructed.
The idea of anchoring bias was not created by considering the financial market. Rather, it was developed in the 1970s by Amos Tversky and Daniel Kahneman to describe how individuals make decisions and how systemic bias shapes their perspective.
The idea behind it is a little simple to understand, particularly when explained through an example.
When purchasing an automobile, for instance, a person might establish a standard using the first model they come across. Every other model is evaluated using the initial model as a point of reference.
Therefore, if the second automobile costs $180,000 and the first automobile costs $200,000, the buyer might think the second car is less expensive. But this is only because they are comparing the second automobile to the first, even though it’s plausible that the first was worth money, whereas the second was overpriced.
This is due to people’s tendency to develop specific mental frameworks and plans when they first learn something.
All subsequent information gets skewed as individuals try to fit new information into already existing frameworks and they become anchored to particular frameworks.
This phenomenon can be observed through historical prices in the context of investment. An investor can get anchored on the purchase price of a security rather than its true worth.
How does Anchoring Bias Influence Trading?
People might be seriously duped by anchoring bias when it comes to trading or investing. It may cause a trader or investor to make a wrong financial choice, such as they may buy an asset for more than its actual worth or they may sell it for a lower worth. Anchoring can be present at any point of the financial decision-making process and is one of the major reasons behind bad financial choices on the part of investors and traders.
Some of these situations are:
- Overpaying for Assets: You can be more inclined to purchase an asset at a higher price than its actual worth if you are anchored on a high price for an asset.
- Selling Assets Too Soon: If you’re anchored to a cheap price for an asset, you can sell it too early before it has had a chance to rise in value.
- Making Bad Investment Decisions: Anchoring bias might cause you to make bad investment decisions since it can sway you in the direction of irrelevant information.
High water marks, historical prices, volume of sales, and financial indices are some most common anchors. You may end up disappointed if you use them as your main point of reference when making financial decisions.
Anchoring Bias Example in Trading
Let’s assume, what approach would you take if I asked you to predict the position of Apple’s stock in three months? Many individuals will first ask about what is the current position of the stock. After that, they will estimate where the stock will be in three months based on where it is now. This is a form of anchoring bias. We begin with a price today and we build our sense of worth according to that anchor.
Similarly, if someone tells you that a stock is worth $100, you might be more inclined to purchase it even if it has since dropped to $90.This is because you’re anchored to the starting information of $100, and you can be hesitant to sell it for less than that.
Why is Anchoring Bias Dangerous?
There are only a few elements to be highlighted, but they are very crucial. A possible dangerous mistake can be to focus all our analysis, including fundamental and technical, as well as price action on the initial value that we observe. If, for instance, we examine a stock and find a trend signal, the risk might be that we fail to look for potential reversals.
This brings us to our second point: making poor trading judgments that result in losses. Let’s return to the earlier example: our trade would undoubtedly be negative if we enter it based on a bullish trend and it reverses.
Moreover, the set benchmarks are somewhat dangerous as they put traders at a greater risk while potentially leading them to miss out on profitable opportunities.
Anchoring bias is trickier to identify because it is easily linked with other cognitive biases like confirmation bias or overconfidence. The “status quo bias” and the “halo effect” are two other harmful biases that might be mentioned.
How to Avoid Anchoring Bias & Make a Profit in Trading?
Anchoring bias poses significant hazards when trading financial markets. Any trading decision ought to be grounded in the most recent information rather than historical values or data. Although avoiding anchoring bias can be difficult, there are a few steps one can take to prevent it.
- Be Aware of Anchoring Bias: Being conscious of anchoring bias is the first step towards conquering it. You can begin looking for solutions to avoid it as soon as you are aware that it exists.
- Consider all Available Information: Don’t rely just on the initial piece of information you receive when making financial decisions; instead, keep an eye on all available information.
- Conduct Thorough Research: Traders need to conduct thorough research and confirm trends. Their trading decisions should not be emotionally driven or based on the initial number or value heard or seen.
- Review your Choices: It’s also critical to go back and review your investment choices often. This will assist you in making sure that you are not being swayed by anchoring bias and that your decisions remain valid.
- Alternate Scenarios: Another way to prevent anchoring bias is to always consider all alternative scenarios whenever you open a trade. By taking your time, you can sketch out multiple choices instead of relying on one data point. Consider other scenarios, for instance, if the Relative Strength Index rises above the overbought level. Analyze other indications in this particular case and the cause of its rising movement.
- Diversify the Portfolio: Invest in several forms of assets and instruments to diversify your holdings and possibly prevent over-attachment to any one of them.
- Discourage Impulsive Decisions: Traders should use rule-based trading that promotes logical thinking instead of making impulsive or wrong decisions.
How may Anchoring Bias be Advantageous?
You can benefit from anchoring in a certain way. You can first set a greater price if you’re selling something or negotiating a wage for a new position. This will establish an intellectual anchor in the other individual, making your subsequent offer appear attractive to them.
Conclusion
Anchoring bias can be destructive when it comes to trading. You can increase the quality of your investing decisions and produce outcomes with higher returns by being aware of anchoring bias and taking action to combat it.
