Behavioural finance: anchoring

In this article, we will explore a few of the key concepts that the pioneering behavioural finance researchers have identified as contributing to traders' irrational and often detrimental financial decisions.

Our ideas and opinions should be based on relevant and appropriate facts in order to be considered valid. However, this is not always the case. The concept of anchoring is based on our tendency to attach or "anchor" our thoughts to a reference point, even if it is not logical or is irrelevant.

This phenomenon may seem unlikely, but anchoring is rather common in situations where people are struggling with new concepts.

The diamond anchor

Let's examine a classic example: conventional wisdom suggests that a diamond engagement ring should cost the equivalent of two months' salary. Believe it or not, this "standard" is one of the most illogical examples of anchoring. This totally random benchmark was created by the jewelry industry to maximise their profits, it does not a measure a couple's mutual love in any way!

Many men cannot afford to spend two months' salary on a ring. However, some men go into debt in order to meet the "standard". Logically, the amount spent on an engagement ring should be dictated by what a person can afford to spend. But the power of anchoring leads many men to follow this "standard" no matter the expense.

Academic proof

Of course, the two-month standard given in this example seems relatively plausible. However, academic studies have shown that the anchoring effect is stronger when it occurs in situations where the anchor is totally random.

In 1974, in an article entitled "Judgment under uncertainty: heuristics and biases", Kahneman and Tversky conducted a study in which a wheel containing the numbers 1 to 100 was spun. Then, the subjects were asked if the percentage of African countries that are UN members was greater than or less than the number of the wheel. Tversky and Kahneman found that the random anchor value of the number on the wheel had a significant effect on the response that the subjects gave. For example, when the wheel landed on 10, the average response given by the subjects was 25%, whereas when the wheel landed on 60, the average response was 45%. As you can see, the random number had an anchoring effect on subjects' responses.

Anchoring investments

Anchoring can also be a source of frustration in the financial world, as investors base their decisions on relevant data and statistics. For example, some people invest in the stocks of companies that have declined dramatically in value in a very short time. In this case, the investor's anchoring is linked to the stock's latest high, as he believes that the price drop is a good buying opportunity.

It is true that the variability of the overall market can result in the decline of certain stocks, which allows investors to take advantage of this short-term volatility. However, the value of a share often declines because of changes in the underlying fundamentals.

For example, assume that stock XYZ achieved a good performance last year and that the share price rose from $25 to $80. Unfortunately, one of the company's main clients - which represents 50% of XYZ's turnover - decides not to renew its purchase agreement with XYZ. This change of events causes a drop in the share price from $80 to $40.

By anchoring the previous high of $80 and the current price at $40, the investor mistakenly believes that XYZ is undervalued. The shares are not sold at a discount, though, because the decline in value is caused by a loss of revenue due to the departure of a major client. In this example, the investor is plagued by the risk of anchoring.

Avoiding anchoring

When it comes to avoiding anchoring, there is no substitute for rigourous critical thinking. Be especially careful in terms of the numbers you use to evaluate a stock or currency pair's price potential. Successful investors don't just base their decisions on one or two reference points, they evaluate each opportunity from a variety of perspectives in order to get the most accurate picture of the investment landscape.