Behavioural Finance - The power of the anchoring effect
Knowing that your host prefers white wine, and wanting to make a good impression, you start looking at the more expensive wines and spot a cheeky little Sancerre priced at £22. Thinking this may be too much to spend on one bottle you decide to look elsewhere but then notice that this wine is reduced to £12 for today only! Although this is still more than you were wanting to pay, £10 off seems like a great deal and your friend will be impressed with your choice of wine and so you go ahead and buy it. Little do you know that you have just been unduly influenced by the anchoring effect.
What is the anchoring effect?
The anchoring effect describes our tendency, when making decisions, to depend on the first piece of information that we receive (the “anchor”).
During the decision making process, many of us concentrate on a particular number such as the price of an item or asset and this becomes a mental reference point or “anchor”. Once this fixed anchor point has been created, we tend to focus on this initial value and rely too heavily on it when making subsequent decisions, instead of conducting a complete analysis on which to base our choices. In the case of the bottle of wine above, compared to the initial purchase price quoted, the “reduced” price seems like a great deal. The anchor is convincing us that we are getting a bargain.
Reference points versus rational thinking
Of course, in the context of buying wine, there isn’t a lot at stake if we let the anchoring effect take hold. However, making similarly under-informed decisions when it comes to financial planning and investing can have much more significant consequences.
The problem for all of us, as we come to make important financial choices, is that we struggle to avoid basing our decisions on certain reference points (or anchors) that we have in mind.
For example, the anchoring effect can be seen when investors watch the price of an investment fall and then refuse to sell it until the previous high price is matched. In reality, the earlier high price has no direct relation to where the stock price may go in the future but it has now become an anchor. This can potentially lead to faulty decision-making particularly given that there is no guarantee that the anchor value will ever be attained again.
Reference points can be very useful in certain situations and they help us arrive at decisions when we might otherwise struggle to make up our minds. You wouldn’t want to spend hours and hours deciding which bottle of wine to buy on the basis of in-depth research or by poring over reams of relevant data.
However, when it comes to making investments, when more is at stake, it is in our best interests to exhibit more rational thinking and to allow ourselves to be guided by good sense, relevant data and expert advice. It makes sense to equip ourselves with whatever research we can get our hands on and to make careful considerations so that we can maximise our chances of getting our decisions right rather than resorting to reference points, which may well be much less important and relevant than we think.
In order for individuals to digest and take on detailed financial information and understand the variety of options open to them, effective communication is vitally important.
Unfortunately, even the most focussed and determined of us will struggle to really get a sense of what matters most if the information is not being communicated in an effective way.
This in turn can leave us resorting to our old anchor points and their underlying interpretations as we weigh up our options and think about how best to invest for the future.
Only by appreciating the power of the anchoring effect can we enhance our decision making by not only considering our initial thoughts but also taking account of other relevant factors as well.