Anchoring and Adjustment

A cognitive heuristic that influences how people assess probabilities in an intuitive manner

What is Anchoring and Adjustment?

Anchoring and adjustment refers to a cognitive heuristic that influences how people assess probabilities in an intuitive manner. According to the anchoring and adjustment heuristic, people employ a certain starting point (“the anchor”) and make adjustments until they reach an acceptable value over time. The heuristic was first hypothesized by psychologist and economist Daniel Kahneman and cognitive psychologist Amos Tversky.

 

Anchoring and Adjustment

 

The Mechanism of Anchoring and Adjustment

Anchoring is a cognitive bias found in people, where they rely on facts provided before a decision or an estimation is made. The facts may be completely unrelated or even absurd, but research shows that they significantly impact the outcome.

Anchoring is understood to be a subconscious or semiconscious phenomenon, while adjustment around the anchor is very much a conscious decision. The mechanism that drives the anchoring effect is related to a similar concept called suggestion.

 

Anchoring via suggestion

An adjacent idea to anchoring is the idea of suggestion. Suggestion is when one makes an estimation based on some association and makes adjustments based on the same.

For example, a study found that estimated prices of cars from luxury manufacturers like Audi or Mercedes were consistently higher than those for Volkswagen, which is a mass-market manufacturer. The difference is because people associate the car manufacturers with certain characteristics in their memory. It forms the basis of semiconscious anchoring.

 

Subconscious anchoring

Subconscious anchoring happens when there is little to no association that a person makes, or the anchor is obviously incorrect. In such a situation, either the person imagines a situation in which the anchor may be correct, or the incorrect anchor can still induce a suggestion that could lead to anchoring as described above.

 

Experimental Results

In the next sections, we will see how the effect is measured and go over results from some of the key experiments.

 

Anchoring Index

The anchoring index is the measure of the impact of anchoring on experimental outcomes. It is calculated as follows:

 

Anchoring Index

 

Where:

  • ∆ Estimate – Difference in average estimates of those given higher anchor and lower anchor
  • AH – The high anchor
  • AL – The low anchor

 

Experiments

In one experiment, visitors to the San Francisco Exploratorium were asked two sets of questions about the height of the tallest redwood tree. The questions were:

  1. Is the highest redwood tree taller or shorter than 1,200 feet?
  2. What is your guess about the height of the tallest redwood?

 

The other set of questions were the same, but the anchor was 180 feet.

  1. Is the highest redwood tree taller or shorter than 180 feet?
  2. What is your guess about the height of the tallest redwood?

 

The result of the experiment above illustrated the anchoring effect. The visitors who were given the 1,200 feet anchor guessed, on average, the height to be 844 feet. On the other hand, those given the 180 feet anchor produced an average estimate of 282 feet. The anchoring index in our case was (844 – 282) / (1200 – 180) = 562 / 1020, which is approximately 55%.

In another experiment conducted with real estate agents, the agents were given booklets with information on houses, including an asking price for the house. They were then asked to evaluate the properties. Contrary to the claims of the participants, the asking price did indeed serve as an anchor.

The valuation for the properties showed an anchoring index of 41%. It was only marginally better than business school students with no real estate experience who demonstrated an anchoring index of 48%.

 

Anchoring and Adjustment Effect in Finance

Anchoring and adjustment can be seen in many situations in finance. For example, one may get anchored to the result of a valuation model and make decisions or negotiate around it. It ignores the model error that arises from incorrect assumptions or if the model is suitable to begin with.

Sometimes, people may be anchored to figures in a plan or a forecast that may not be relevant to the current situation. Hence, it is important to notice if one is being anchored and make a conscious effort to re-evaluate decisions and seek feedback.

 

Additional Resources

CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Belief Perseverance
  • Framing Bias
  • Emotional Intelligence
  • Bandwagon Effect

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes and training program!