Anchoring bias in finance is using irrelevant information, such as the purchase price, as a baseline for evaluating or estimating an unknown value of a financial instrument. Anchoring means that people see recent price levels as fair for their stock. Unfortunately, they ignore or at least are slow to incorporate new information.
Researchers have found dozens of unconscious biases that can drive people to make crazy decisions – money included, they later regret.
Take the behavioral economics concept known as “anchoring,” for example. Anchoring is one of the most potent and dangerous phenomena in trading.
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Anchoring Bias in Finance Example
Imagine this scenario: you inherit a painting from your late grandmother’s estate. Attached to the painting on the back is a handwritten note saying it’s worth $5 million. A bit of time passes, you lose your job and find yourself financially in a tight spot. You then decide to put the painting for sale. Collector offers you $1 million for the piece; you turn it down immediately because you “know” it’s worth $5 million.
A few weeks later, a museum calls and offers you $6.3 million for the painting, which you happily accept. Not long after, you discover it’s worth at least $12.5 million. How do you think you would feel? Well, I think it’s safe to say you will feel very crappy for leaving money on the table. Instead of making a profit, you’d feel foolish knowing there was an opportunity to earn more.
What I explained above is an example of a psychological trap known as anchoring bias. Unfortunately, anchoring bias in finance happens when you give more weight to the initial information (the anchor) when deciding which action to take.
Anchoring in Action
Anchoring bias in finance can take on several forms. Let’s look at a stock trading around $100 a share for the last year. Since that’s the price, we think of $100 as a fair value for that stock. Consequently, we don’t take into account the fact that they announced high earnings last week.
Or that they did a transformative deal or something similar. For example, pretend that you own ROKU and Tesla stock. What do people do if ROKU stock rises from $100 to $200, and Tesla has fallen from $150 to $80? They think, “Oh, Tesla’s so cheap here, it will return. And ROKU’s gotten too expensive; it’s going to fall.”
Then, they act accordingly. You get it. They sell ROKU, which is doing well fundamentally, without taking the time to analyze it. ROKU doesn’t fall, nor does Telsa recover. They’d see that Telsa wasn’t a deal because the fundamentals don’t support a comeback; it hasn’t hit rock bottom yet. But nope, once again, a decision was made irrationally, and they bought Telsa in error.
If you have a specific and perhaps arbitrary number in mind that sways your decision-making, you’ve fallen prey to anchoring. Another scenario might be buying a stock that briefly rose from trading around $65 to hit $80 and then fell back to $65 because it’s now a bargain (anchoring your strategy at that $80 price).
What about selling Facebook just because the company’s stock hit a round number, like $300 a share? Or, worse yet, the “endowment effect.” This phenomenon can cause you to overvalue something simply because you own it—the result is that you cling to a tanking stock.
Common Anchors
Historical values, like acquisition prices or high water marks, are common anchors. Likewise, one of the most common anchor traps in investing is past events and trends. Investors look at the historical values of a particular stock, become anchored to them, and base investing decisions on them. Consider the potstock sector, for example. It doesn’t mean that because it trended nicely in the past, it will trend nicely in the future.
In this scenario, past figures show the stock’s historical prices over a certain period. But they will fail to capture the rapid changes in the market. So, this could cause quite an anchoring bias in finance.
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How Does Anchoring Bias Affect Decision Making?
Anchoring bias in finance will affect your decision-making because you’re irrationally fixated on one thing. For example, I like the “Ride the 9” strategy in trading. It’s a strategy in which you use the 9 EMA to get in and out of a trade. And while in that trade, you ride the price up or down. Now, if I became so fixated on trading that way that it affected how I got in and out of trades, I’d bet money I’d be a terrible trader and one of the 90% that fails. Being so obsessed with one way of doing things can cripple your trading.
Anchoring and Risk
In the context of trading, one consequence of anchoring is that traders tend to hold stocks that have lost value. This is because they anchored their fair value estimate to the original price rather than the fundamentals. You might have heard this referred to as “bag holding.” These so-called “bag holders” assume a greater risk by holding, and the stock will return to its purchase price.
Traders are often aware that their anchor is faulty and attempt to make adjustments to reflect subsequent information and analysis. However, these adjustments often produce outcomes that reflect the bias of the original anchors.
But I’m smart. I won’t fall victim to Anchoring bias in finance. You may be smart, but 1,000 years of conditioning have naturally caused the human brain to form estimates. When you think about it, it’s pretty hard to decide without having estimates or comparing its worth.
The leading cause of anchoring is uncertainty. In the face of uncertainty, it is normal for one to determine value based on past historical information.
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How to Prevent Falling Victim
The best way to overcome the psychological trap of anchoring is to be aware of it. Like anything, awareness is the first step to reducing the chance of using anchoring when making decisions.
Once you are aware, you can build habits into your trading strategy that allow you to overcome the bias.
As humans are prone to giving disproportionate weight to the initial information one receives, doing your research is a great way to overcome anchoring bias.
In other words, do your due diligence. I suggest you look at the facts from various perspectives. Keep questioning the so-called “facts.” How do you know they are accurate? Gather the evidence, compile it, and decide based on well-researched information.
Final Thoughts: Anchoring Bias in Finance
For these reasons, I can honestly say that making good investment and trading decisions requires rational and logical thinking. When we take the time to examine bad choices (i.e., losing trades), we can usually trace them back to the way we made the decisions.
Perhaps you didn’t follow a strict trading plan with specific trading criteria. When you fail to identify the why and engage in critical thinking, you fall victim to this hidden trap in easy decision-making.
Your job as a trader is to protect yourself. Don’t be your own worst enemy when day trading. Don’t let anchoring bias in finance make you a bad trader.
