Investment decisions require rational and logical thinking. Just the way a good house needs a solid foundation, the ideas and opinions for investment also need to be based on logical and relevant facts. However, this is not always the case. The economic choices are largely influenced by the extraneous factors.
As a result of the behavioural biases, the investment decisions of the investors get affected by illogical and irrelevant data. One of these biases is the Anchoring Bias. It makes the investors base their investment decisions on a reference point that may not have any relevance to the decision at hand.
It's no secret that ESG (environmental, social, governance) factors have become more important in investing. Fund managers are increasingly incorporating ESG factors into their portfolio allocations. However, those that don't are in danger of being left behind as investors increasingly avoid allocating with funds that don't incorporate ESG into their allocations. Q3 2021 hedge fund Read More
Anchoring bias is the tendency to use first impressions to form perceptions. These initial perceptions affect the later decisions. The individuals with the anchoring bias tend to anchor the thoughts to an irrelevant reference point. Values are assigned to one option based on how attractive the option is compared to the other options, instead of analysing each option on its own.
In daily life, a good example of anchoring effect is the discounted price of products. If one product has the selling price of $50, and the other product, with an original price of $80 is being sold at $50 after discount, the second product is always preferred. The original price of the products is used as the reference point, and the decisions are made based on how much is the discounted price compared to the original price. Although the original price has no relevance to the price the product is being sold at now, still the buyers anchor their decisions on it.
In terms of investment decisions, the anchoring bias makes the investors reject sound financial decisions, and makes them take less than ideal financial decisions. The historical values of the securities are considered as anchors and the investors base their decisions on them, although they have no correlation with the market pricing and target return. When making a final decision, the prediction has to start somewhere, and that initial value has an enormous effect on the final conclusion.
Causes of Anchoring Bias
Like all the other forms of behavioural biases, anchoring bias is also inbuilt within the system of human beings. It is caused due to the way human brains have been conditioned. Anchoring bias is primarily caused by the need of people to form estimates. After an estimate is formed, people start adjusting away from it. Even after the adjustment, people still tend to anchor on the initial value.
It is also caused by uncertainties. Investment decisions are full of uncertainties, therefore they tend to be most affected by the anchoring bias. When the investors are faced with situations that they have not dealt with earlier, they struggle to find something to base their judgements on. At these times, the initial values or the historical values become the anchoring points, however subliminal or irrelevant.
Effects of Anchoring Bias
As a result of the anchoring effect, the investors anchor the fair value estimate to the original price rather than the fundamentals. This makes them hold on too long to the investments that have lost value. By doing so, they take huge risks by holding the investments in the hope that the security will return to the original price.
The anchoring bias can also make the investors make less than ideal financial decisions, like ignoring an undervalued investment or holding the overvalued investment for too long. Overall, anchoring effect leads to bad investment decisions.
Sometimes, anchoring bias also causes the ‘post-earnings announcement drift.’ When the earnings for a company are announced, the stock price under reacts to the new information. It drifts to a new fundamental value, keeping the past stock price as an anchor.
The disposition bias is also an effect of anchoring bias. Disposition effect involves selling of shares whose price have increased and retaining the assets whose value has dropped. In this case, it is the anchoring bias which is causing the investors anchor to the purchase price of the stock.
How to Overcome Anchoring Bias?
As discussed, anchoring effect is caused by the presence of uncertainties. So, in order to overcome it, it is advisable to do a lot of research, well in advance, so that the decisions are based on the full knowledge as anchor, instead of the initial values as anchor.
Once the research is done and good habits are formed, inertia to change is need to remain anchored to the current state. The following investment decisions can then be based on these strong good habits.
It is also critical to reject certain anchors to overcome the anchoring bias. The anchors like historical values and valuation multiples can be harmful to investment objectives, and must be rejected. In the situations where the anchors need to be used, the suppositions should be replaced with quantifiable data.
Thus, anchoring bias can be overcome with objectivity and practical approach. The investors who are disciplined and take research-based decisions are less susceptible to the anchoring bias.