Anchoring in Decision Making – Understanding Behavioural Finance, Part 7
During my chat with Greg Davies, which began with this post, I asked if he could explain the concept of ‘anchoring’, and what the effect of it is on our financial decision-making.
Understanding anchoring in decision-making
“Anchoring is our tendency to infer things from other cues in the environment. One of the first experiments into this was by Daniel Kahneman, the Nobel Prize winner. They constructed a roulette wheel with 100 numbers on it, and got experimental subjects to come in to spin the wheel, which landed on what the subject believed was a random number, but it was rigged.
The subjects were then asked: “What proportion of countries in the UN are in Africa?” a question that most people are unable to answer. In 50% of the tests, the wheel was rigged to land on the number 10, and in the other 50% to land on 65.
Where the roulette wheel ends up has no bearing on the answer to the question, and yet, the group whose wheel landed on 10 gave an average answer of the low 20s. For those where the wheel landed on 65, they estimated around 50% of countries were in Africa.
Applying this to finance
Just as most people can’t accurately answer that question, they also don’t know how much a stock is worth, or where the FTSE will be in six months, so we can see that people anchor onto the things that are around them, even if they’re utterly irrelevant.
In the experiment, people had the number 10 in their heads, and decided that the answer to the question must be higher, so adjusted upwards (but not enough). Anchoring means that we’re all skewed by random things in our environment which influences our decision-making.
Some of the most important things in financial decision-making that can have an influence are: “What price did I purchase this asset for?” and “What are the risk-return characteristics of this asset in the future?” The price you bought it for is utterly irrelevant, and yet it plays a part in the thought process.
Purchase price anchoring
Imagine two investors have bought the same block of stock, and yesterday the stock price was £160, and today it drops to £150. They’ve both lost the same amount of money, but one of them bought the stock a long time ago at £100, and the other bought it fairly recently at £200.
They are mentally anchoring to some degree on the knowledge they have of what price they purchased at, so the two investors will be in very different emotional states, induced by the price change since yesterday.
For the investor who bought at £100, a drop from £160 to £150 will feel like slightly less of a problem, whereas the person who has £200 in their mind thinks: “Wow, it went down to £160 and then to £150” and is in a much more emotionally-charged state.
Those two investors are likely to make very different investment decisions for the same asset in the future, because of something in their memory that is utterly irrelevant to the decision.
Anchoring is important, because we are influenced by all sorts of information, whether it’s recent (the index went up and people chase past performance) or people anchoring on the price they bought at, and having different emotional responses, which they should be excluding entirely.
Losing and winning
People are reluctant to sell losing positions and it applies to professional investors as well as individuals – people hold on to them much longer than they hold onto winning positions. Simply put, selling something that’s gone up feels good: “I bank my gains, what a great investor I am!”
Selling stuff that goes down is me turning a paper loss into a real loss, and admitting to myself I got it wrong. It’s psychologically painful, and I want to hang on to that hope that it may just get back above what I bought it for.
Anchoring on the purchase price leads to very different behaviours. For many investors, there are two difficult things. Buying is difficult, because it’s difficult for me to get out of cash and take the risk, and selling is difficult because I have all the emotional burden of whether the value has gone up or down.”
Next week, I'll bring you the final instalment of my conversation about behavioural fiannce with Greg Davies.