Welcome to the first episode of our new podcast, we are kicking off an educational series where we dig into the psychology that guides our investment decisions. In this kickoff episode, we explore Anchoring Bias, a common trap that can affect even the most seasoned investors.
With expert insights, real-world examples, and practical strategies to overcome this bias, we're here to help you make more informed and rational investment choices.
Whether you're new to investing or a finance professional, this episode is packed with valuable insights. Don't forget to subscribe for more!
Transcript Below
Many of you have told us you want to become a better investor. One of the keys to better investing is an ability to control emotions or biases. Human beings are prone to various cognitive biases which are mental shortcuts and patterns of thinking that can lead to irrational and suboptimal decision-making. When it comes to investments, these biases can have a significant impact on how people perceive and approach financial opportunities.
Dan Ariely, Professor of Psychology and Behavioral Economics at Duke University writes in his book Predictably Irrational:
“We usually think of ourselves as sitting in the driver's seat, with ultimate control over the decisions we make and the direction our life takes: but alas, this perception has more to do with our desires, with how we want to view ourselves- than with reality. Our behavior is influenced by emotions, relativity, social norms etc. And while these influences exert a lot of power over our behavior, our natural tendency is to vastly underestimate or completely ignore this power. These influences have an effect on us not because we lack knowledge, lack practice, or are weak minded. Quite the contrary, they repeatedly affect experts as well as novices in systematic and predictable ways. The resulting mistakes are simply how we go about our lives, how we do business. They are part of us.”
In an effort to help you on your investment journey we are excited to present a series of podcasts that delve into the world of biases to help you better understand these biases and how you can objectively overcome them.
Today we're going to look at Anchoring Bias
Also known as focusing illusion, anchoring bias is a cognitive bias that influences decision-making by giving disproportionate weight to the first piece of information or “anchor” encountered when making judgments or estimates. This initial anchor serves as a reference point from which subsequent evaluations or adjustments are made, even if the anchor is irrelevant or arbitrary.
The anchoring bias can lead individuals to make judgments that are biased towards the initial anchor, resulting in systematic errors in reasoning. Once an anchor is established, people tend to adjust their subsequent judgments or estimates around that anchor, often insufficiently or inadequately.
Let's look at an example of anchoring bias.
Imagine an investor named John is considering buying shares of tech company TechCo that is currently trading at $50 a share. Before making the decision, John looks at the stock’s historical performance and notices that TechCo’s stock price was significantly higher just a few months ago, reaching a peak of $100 a share.
Upon seeing the $100 per share price as an anchoring point, John becomes fixated on it. He starts to believe that TechCo stock is undervalued at its current price of $50 because it once traded at twice that amount. He assumes the stock will eventually return to its previous peak, leading to a 100% gain from his investment.
As a result of this anchoring bias, John decides to buy a considerable number of shares of TechCo at $50 a share expecting the stock to eventually reach the $100 mark again. He disregards other factors that may affect the company's prospects such as changes in the overall market, industry competition, or the company’s financial health.
Unfortunately TechCo stock doesn't perform as John had hoped. The company faces challenges, and the stock price continues to fluctuate, but does not reach the $100 mark again. John's anchored belief in the previous high price leads him to hold on to the stock, hoping that it will eventually rebound. He may be hesitant to sell even when the stock price starts declining further as he has anchored his expectations on the $100 per share mark.
In this example the anchoring bias has influenced John's perception of TechCo stock value. He is fixated on the previous high price of $100 a share, using it as a reference point for evaluating the stock’s current worth. This causes him to overvalue the stock and potentially miss out on other investment opportunities with better prospects.
Here are some reasons why investors may be susceptible to anchoring bias:
1. Limited information processing: When investors encounter new information, they may use the first piece of data as a starting point or reference for making subsequent judgments. This initial piece of information becomes an anchor that influences their perceptions of the value or potential of an investment.
2. Mental shortcuts: Investors often use mental shortcuts to simplify decision making. Anchoring provides a quick and effortless way to assess an investment by relying on a single piece of information.
3. Over confidence in initial estimates: Investors may overestimate the accuracy of their initial estimates or predictions, leading them to anchor their subsequent decisions to those initial estimates.
4. Influence of expert opinions: Investors may anchor their beliefs and decisions in the opinions or recommendations of financial experts or market commentators, especially if these opinions are widely publicized.
5. Difficulty in adjusting: Once an anchor is established, investors may find it challenging to adjust their beliefs or valuations, even in the face of new and contradictory information.
6. Fear of missing out: Anchoring bias can lead investors to anchor their valuation of an investment to the original purchase price or market price at which they acquired it. They may be hesitant to sell if the current market price is below their anchor point, thus incurring a loss only to miss out on a potential price recovery.
7. Attachment to previous experiences: Previous experiences, especially those involving gains or losses, can act as anchors and influence an investor’s perception of future investments.
8. Emotional factors: Anchoring bias can be reinforced by emotional attachment to an investment. Investors may anchor their decisions to the emotional significance of a past price level or investment outcome.
Overcoming anchoring bias requires conscious effort and a willingness to challenge your initial reference points when making investment decisions.
Here are some strategies to help you mitigate the impact of anchoring bias:
1. Be aware of the bias: The first step is to recognize that the anchoring bias exists and understand its potential impact on your decision making. Be vigilant and question your thoughts and assumptions when evaluating investments.
2. Seek diverse perspectives: Encourage input from different sources and seek out alternative viewpoints. Engage in discussions with others who have different opinions about an investment to challenge your anchored beliefs.
3. Conduct thorough research: Rely on data-driven research and analysis when evaluating an investment. Look at a wide range of information such as the company’s financials, industry trends, competitive landscape, and macroeconomic factors to form a more comprehensive view.
4. Consider multiple scenarios: When projecting the future performance of an investment consider various possible outcomes not just a single optimistic or pessimistic scenario. This can help you avoid anchoring your expectations to a specific outcome.
5. Set new anchor points: Instead of relying solely on historical prices or past events, establish new reference points based on current information and market conditions. Focus on the investment’s current valuation and potential rather than past highs or lows.
6. Consult with experts: Seek advice from financial advisors or experts with a track record of providing objective and unbiased guidance. Their insights can help you avoid getting anchored to specific reference points.
7. Practice mental flexibility: Be open to adjusting your opinions and beliefs based on new information and changing circumstances. Avoid being rigid in your thinking and remain adaptable to market developments.
8. Take your time: Avoid rushing into investment decisions. Give yourself time to thoroughly analyze an opportunity and consider the factors that will influence its performance.
9. Learn from past experiences: Reflect on past investment decisions influenced by anchoring bias. Use those experiences as learning opportunities to develop a more objective and critical approach to evaluating investments.
Remember that overcoming anchoring bias is an ongoing process that requires self-awareness and discipline. By actively questioning your assumptions, seeking diverse perspectives, and conducting comprehensive research, you can make more rational and well-informed investment decisions. Being mindful of the influence of anchoring bias will help you develop a more balanced and objective approach to investing.
This concludes the first of our educational podcasts.
🎙️ Exploring the Anchoring Bias - Risk Off Podcast #1 🎙️