Anchoring Bias: What is it and how does it impact our financial decisions?
When you think of the word “anchor,” you likely envision a metal device used to secure a boat or ship, ensuring it does not drift away. However, the concept of “anchor” extends beyond this nautical apparatus and can be related to our thought processes and behavior. An anchor serves as a mental reference point, assisting us to process information and influencing our decision-making. We establish anchors in many ways: through personal experiences, culture, and customs, or even through news media.
These mental anchors often show up in different scenarios. For instance, when asked about the ideal retirement savings, one person may suggest $500,000, while another proposes $3 million. This variation is due to differing personal anchors based on lifestyle choices and geographic locations.
Although anchors can be rational and rooted in prior knowledge, they can also be arbitrary and irrational. Regardless, they have the potential to introduce unintentional bias and cause us to make imprudent choices, particularly when it comes to financial management.
Anchoring Bias and Investing
Anchoring bias occurs when an individual relies too heavily on the first piece of information they receive when making a decision, even if that information is irrelevant or inaccurate. Anchoring bias is often associated with heuristic thinking, a mental shortcut that allows individuals to make quick decisions based on limited information.
Many mental anchors relate to our perception of costs. Take, for example, the price of gasoline. In 1980, a gallon of gas cost $1.22. 1 Not bad, right? If you grew up in that time period, you might have formed a mental anchor to this number, making current prices seem exorbitantly high in comparison to those of the late ’70s.
However, to accurately compare gas prices from 40 years ago to today, we must account for inflation. The inflation-adjusted price goes from $1.22 to $4.51 – more than $1 less than the average price per gallon in 2021.2 Suddenly, the 1980 price doesn’t appear like such a great deal!
Similarly, we may apply anchors to the world of investing, and specifically the pricing of securities. Imagine purchasing a stock for $1,000, only for its value to decrease to $800. You might be inclined to buy more of the security at the reduced price, considering it a “bargain.” However, it’s possible that the security was initially overvalued, and the new price represents its true value.
It’s important to note that adding an overvalued security to a portfolio isn’t always a bad thing. Some high-priced stocks can be suitable investments if the company is successful and sustainable with an optimistic forecast. The key is to recognize the influence of anchoring bias on our financial decision-making and use this awareness to reinforce critical thinking, leading to well-informed investment decisions.
Using Anchoring Bias to Forecast Investment Prices
Anchoring bias also occurs when investors make market decisions based off recent performance. It seems natural to think that if the price of a security is higher at the close of the market, the upward trend will continue the following day. In some cases, we’ve anchored to an expectation that the price will continue to climb, and this false thinking could cause investors to hold on to securities longer than they should. (Inversely, it could also cause some investors to sell securities too quickly when prices drop.)
How to overcome Anchoring Bias?
Unfortunately, we all know too well that stock market performance doesn’t always align with our expectations. So how do we go about overcoming our natural anchors as investors? The key is to recognize when we’re relying on outdated or even incorrect information to make financial decisions. We also need to adopt a future-driven mindset that’s flexible enough to change based on present circumstances.
At Moran Wealth Management®, we help investors overcome financial biases to make well-informed investment decisions. We carefully craft solutions to your unique vision with support, objectivity, and transparency. To schedule your complimentary consultation with one of our certified financial advisors, call (239) 920-4440 or visit https://moranwm.com/about/#consult.
1 Nicolas Vega. CNBC. April 13, 2022. “A gallon of gas was 65 cents in 1978 – here’s how much it cost every year since.” https://www.cnbc.com/2022/04/13/how-much-gas-cost-every-year-since-1978.html. Accessed Feb. 22, 2023.
2 Ibid.
3 Wikipedia. “GameStop short squeeze.” https://en.wikipedia.org/wiki/GameStop_short_squeeze. Accessed Feb. 22, 2023.
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