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FINANCIAL CHRONICLE™ » FINANCIAL CHRONICLE™ » Anchoring, The Mother of Behavioural Biases

Anchoring, The Mother of Behavioural Biases

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sriranga

sriranga
Co-Admin
Just as an anchored ship rarely strays too far away from its tethering point a human being prefers to stick close to the references with which they feel most comfortable. Anchoring is an easy-to-demonstrate, hard-to-eradicate behavioural bias that has all sorts of nasty implications for investors, many of them not obvious. In fact, along with availability, it has the claim to be the mother of all biases.

The fundamental investment problem lies in the difficulty in deciding what something is intrinsically worth. A skilled negotiator will start from an extreme position, such as a very high price, in order to frame the subsequent discussions. Anywhere and anytime someone presents us with a number in order to start negotiations we’re being anchored. So if it really matters then you need to start from your own number or walk away.

Random Pricing
Anchoring is almost trivially easy to demonstrate and it’s been replicated many times by many researchers in many situations. Perhaps the simplest example is to use peoples’ social security numbers as a reference. As Dan Airely shows here, by simply getting people to write down the last two digits of the number and then asking them to submit mock bids it’s possible to get people with higher numbers to bid up to twice as much as their lower number companions. Unconsciously the brain sets the social security derived number as the reference point and then adjusts accordingly.

It’s worth dwelling on that. I think it’s simply astonishing and truly shocking that highly evolved, smart primates like ourselves can be fooled into utterly stupid behaviour through a trivial piece of misdirection. And it affects us all.

Anchoring is a particularly pervasive problem and occurs in all sorts of scenarios, being particularly beloved by opinion poll surveyors, real-estate agents, stockbrokers, car salesmen, supermarkets and, well, virtually everyone who wants us to buy things. Wherever and whenever anyone presents us with a number and then asks us to do something with it you can be sure we’re be tricked into behaviour that probably isn’t in our best interests.

Multiple Choice, Multi-Buys
Multiple choice surveys on some kind of sliding scale are an especially fun source of anchoring issues since people will invariably anchor on the middle values. Ask people how many times a week they brush their teeth on a scale of 0 to 20 and they’ll be pulling out the old toothbrush somewhere in the middle of the range. Change the scale to 0 to 40 and they’ll suddenly double their efforts.

Supermarkets use this to generate more sales. Whenever you seen a multi-buy offer – buy five for the price of four, etc – you’re seeing anchoring in action. Even if they don’t take up the offer people who normally only buy one or two of the item will buy three or four. What are they thinking? Well, they’re not of course.

Anchoring Under Uncertainty
What Ariely demonstrates is that when operating under conditions of uncertainty – when we’re unable to accurately assess the value of an object – we can easily be overcome by our own behavioural biases, without even realising. Setting a price based on an arbitrary number is clearly stupid and it’s something that the majority of us wouldn’t do if the decision is clearly presented to us. But it’s not and we do.

When you start looking for it anchoring appears in all sorts of places. Consider how analysts decide whether to upgrade or downgrade a stock. Do they start from a fundamental analysis and make a clean decision? Or do they look at the previous rating and making a judgement on that basis? It’s not hard to guess that most broker recommendations are anchored and adjusted from previous ratings – which themselves may have been subject to the same effects. It’s little wonder that recommendations can drift away from reality over time.

Mystery Stock Buyers
Quite how or why many investors decide on a buying point or price is often a bit of a mystery but frequently the reason can be found in anchoring effects. Investment analyst recommendations are one possible anchor, which is a bit like a ship dropping an anchor on a submarine in a hurry, but many investors and investment managers don’t need outside assistance. The classic anchor, of course, is a buying price. We’ve seen how loss aversion often means that investors fail to sell losers and get rid of their winners but it’s a bang-on certainty that anchoring plays a part in this behaviour.

Overall portfolio value is another classic anchor. You frequently find investment bulletin board discussions peppered with references to individual investors' peak portfolio values while fund managers are often compared to such benchmarks. Yet high tide marks are, by definition, peak events: you’ll spend most of the time watching the tide sway in and out so why make yourself miserable by benchmarking on a random event?

Price or Value?
No doubt readers can think of other anchors, they’re everywhere when you start looking. However, as the Ariely example indicates, the underlying problem is that people are being unconsciously biased to assign a value to an item based on what is, essentially, a random number. Given how easy this is to do and how hard it is to stop ourselves from doing we really need to learn how to distinguish price and value.

Experienced value investors will rarely make the mistake of overpaying for a stock because they start from the basis of an intrinsic value computation. Although such calculations are themselves fraught with uncertainty by building in a margin of safety they’ll start any negotiation with a clear and reasonably objective view of what a fair price is. If you know that the case of fine wine has a real value of about $100 you’re unlikely to be biased by some unconscious trigger into bidding double or triple the true worth.

Framed
The ability to distinguish price and value is a key difference between those people we can loosely term “amateurs” and “professionals”. You’ll find plenty of amateurs in the professional investment industry and lots of professionals in the ranks of the private investor. This accords nicely with the research of John A. List indicating that experienced traders are more likely to trade an item when offered a good price than less experienced people.

Some of List’s ideas, which mainly target loss aversion, have been thrown into question by research which suggests that even professionals are loss averse. However, it’s possible that this is to do with the frame in which the research is conducted. Framing is parasitically attached to anchoring and deserves its own extended treatment but basically by presenting the same situation in different ways a frame can cause people to anchor onto different aspects of the problem.

So, for instance, if you present a problem in terms of the possible losses then people will tend to opt for the situation which avoids those losses and become risk takers. However, if you make people anchor on the gains to be protected then they’ll become risk adverse. Almost everywhere you look in behavioural finance you’ll find anchoring somewhere.

The Dumb Shall Inherit the Money
Given how easy it is to trigger anchoring and how prevalent it is in everyday investment then there are really only two ways to address the problem. One is to do the hard yards and learn how to distinguish price and value. The other is to assume that you can’t tell the difference and that, over long periods, the effects of buying too high and too low will average out: avoid the anchors completely by acting dumb.

One thing is definite – we can’t avoid the problem. The best we can do is to learn to deal with it where and when it’s important. Only you can decide as to whether that’s in stock buying, house purchases or simply the weekly supermarket sweep. However, you can be sure that where there’s a price there’s an anchor.
Source:http://www.psyfitec.com

http://sharemarket-srilanka.blogspot.co.uk/

Kumar

Kumar
Senior Vice President - Equity Analytics
Senior Vice President - Equity Analytics

The ability to distinguish price and value is a key difference between those people we can loosely term “amateurs” and “professionals”. You’ll find plenty of amateurs in the professional investment industry and lots of professionals in the ranks of the private investor. This accords nicely with the research of John A. List indicating that experienced traders are more likely to trade an item when offered a good price than less experienced people.

Good one.
Thanks for sharing.

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