What is Anchoring Bias?
Anchoring bias is the theory that people rely too much on pre-existing informational and the first data points they receive when making decisions. For example, if you first see a T-shirt that costs $1,200 and a second one that costs $100, you may believe the second shirt is cheap (relative to the anchor) when you otherwise would not think that. In this case, the anchor (first T-shirt price) influenced your opinion. Anchors are 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. We’re starting with a price today, and we’re building our sense of value based on that anchor.
Learn more in CFI’s Behavioral Finance Course.
Anchoring in Public Markets
Anchoring is dangerous but is prolific in the markets. Anchoring, rather the degree of anchoring, is going to be heavily determined by how salient the anchor is. However, the more relevant the anchor seems, the more people will tend to cling to it. The more difficult to value something, the more we 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 the 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? As it says here, there’s no substitute for rigorous critical thinking. When you approach evaluation instead of looking at where the stock is now, why not build up a first principles evaluation using DCF and see where it lies. When analysts find that their evaluation is far out from the actual stock price, they will then try to change their evaluation to match the market because again, they’re being influenced by the anchor instead of trusting their own due diligence.
More reading: Not All Anchors Are Created Equal.
Thank you for reading CFI’s guide to understanding how anchoring bias works. To learn more, check out CFI’s Behavioral Finance Course.
Additional relevant resources include: