by FPA member David Zuckerman, CFP®, CIMA®
Last Updated: October 15, 2012
Have you ever heard an investor say that a poorly performing stock shouldn’t be sold until the price rebounds to its original purchase price? The instinct to use the purchase price of a stock to dictate the level at which an investor is willing to sell is a prime example of anchoring bias.
Logically, the historical purchase price of a stock should have no bearing on a stock’s intrinsic value, which is determined by current fundamentals like expected earnings and dividends. Traditional economics holds that investors act logically and make rational decisions, but the reality is that many investors allow arbitrary numbers like purchase price to influence the way that information is processed.
The Anchoring Index
In order to illustrate anchoring bias in action, answer the following questions:
Is the height of the tallest redwood more or less than 1,200 feet?
What is your best guess about the height of the tallest redwood?
These questions were answered by a group of participants, with a mean estimate of 844 feet for the second question, which is about three times the actual height of a very tall redwood. A different group was given the same second question, but the height value in first question was changed from 1,200 feet to 180 feet. The results from this second group illustrate the powerful effects of anchoring bias, as the mean estimate fell to 282 feet. Rather than try to reason that a 1,200 foot tree would approximate a 120 story building, people assume that there must be some factual basis to the hypothetical height value, so they adjust their estimates accordingly.
The anchoring index is the ratio of the differences expressed as a percentage. In the example, the difference between the two estimates (562 feet) is divided by the difference between the two anchors (1,020 feet) to arrive at 55%. According to Nobel laureate Daniel Kahneman, the 55% anchoring index measure is fairly typical of similar experiments.
Listing Prices Affect Estimates of Home Values
Stocks are not the only aspect of personal finance that is affected by anchoring bias. An experiment asked real estate agents to estimate the value of homes on the market. The agents visited the homes and were provided with comprehensive information about the homes, including an asking price. Half of the agents were given an asking price that was significantly higher than the actual listing price, and half were given a price significantly lower than the actual listing price. Each agent was asked to provide an opinion about a reasonable buying price, and the lowest price at which the agent would sell the home if it were their own. The agents were also asked to list the factors that affected their estimates. The asking price was not cited as a factor in the agents’ price estimates, as the agents emphasized their ability to ignore asking prices when estimating home values. The results, however, tell a very different story.
The effect of anchoring bias, as measured by the anchoring index, was 41% for the agents in the experiment. Business school students with no real estate expertise were given the same experiment, and fared only slightly worse with an anchoring index of 48%. The main difference is that the students admitted that their estimates were affected by listing price.
Arbitrary Rationing is Effective Marketing
Advertisers often take advantage of anchoring bias by placing arbitrary rations on certain products. A study of a Campbell’s soup sales promotion was conducted when the product was on sale for about 10% less than regular price. On some days a sign on the shelf said “Limit of 12 per person” and on other days the sign said, “No limit per person.” Shoppers purchased an average of 7 cans of soup when the limit was in effect, double the amount that they purchased with no limit.
Prestige branding also relies on anchoring, whereby products are made to appear more valuable because of “limited edition” badges and higher relative prices. Experiments at restaurants have shown that consumers can think that the same menu item tastes better when prices are higher.
Anchoring in Negotiations
As one of the pioneers in the field of behavioral finance, Daniel Kahneman was able to use his insight into anchoring bias to offer practical advice on negotiating. When you encounter an outrageous proposal from the other side, do not counter with a “reasonable” number that is far lower, as the large gap between the two proposals may be too great to overcome. Rather, make a scene and act as if you are insulted, and even threaten to terminate the negotiation. It is critical to let the other party know that you will not continue negotiating with that number as the starting point.
One of the best ways to prevent yourself from falling victim to anchoring bias in negotiations is to focus on arguments against the anchor provided by the other party. Make a conscious effort to think about the lowest offer that the opponent would accept, and emphasize how much not getting the deal done will cost your opponent. A strategy of “thinking the opposite” is generally an effective way to negate the effects of anchoring bias in negotiations.1
Anchoring can be especially detrimental to individuals who make investment decisions on the basis of old purchase prices, inappropriate assumptions, or unrealistic goals. If you need help ensuring that your investment portfolio and personal finances are not held hostage by anchoring bias, consider consulting a CERTIFIED FINANCIAL PLANNERTM from the Financial Planning Association® with the experience and expertise necessary to guide you.
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, CA. He serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.
1 Daniel Kahneman, Thinking, Fast and Slow, (Farrar, Straus and Giroux, 2011), 119-128