How the first data point we see impacts our decisions
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Anchoring bias occurs when people rely too much on pre-existing information or the first information they find when making decisions. For example, if you first see a T-shirt that costs $1,200 – then see a second one that costs $100 – you’re prone to see the second shirt as cheap. Whereas, if you’d merely seen the second shirt, priced at $100, you’d probably not view it as cheap. The anchor – the first price that you saw – unduly influenced your opinion. Anchoring bias is an important concept in behavioral finance.
Anchoring Bias Example in Finance
If I were to ask you where you think Apple’s stock will be in three months, how would you approach it? Many people would first say, “Okay, where’s the stock today?” Then, based on where the stock is today, they will make an assumption about where it’s going to be in three months. That’s a form of anchoring bias. We’re starting with a price today, and we’re building our sense of value based on that anchor.
Anchoring bias is dangerous yet prolific in the markets. Anchoring, or rather the degree of anchoring, is going to be heavily determined by how salient the anchor is. The more relevant the anchor seems, the more people tend to cling to it. Also, the more difficult it is to value something, the more we tend to rely on anchors.
So when we think about currency values, which are intrinsically hard to value, anchors often get involved. The problem with anchors is that they don’t necessarily reflect intrinsic value. We can develop the tendency to focus on the anchor rather than the intrinsic value.
Avoiding Anchoring Bias
So, how do you guard against an anchoring bias? There’s no substitute for rigorous critical thinking. When you approach evaluation, instead of looking at where a stock is now, why not build up a first principles evaluation using DCF analysis? When analysts find their evaluation is far out from the actual stock price, they often try to change their evaluation to match the market. Why? Because they’re being influenced by the anchor instead of trusting their own due diligence.
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