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6.3.2 Anchoring

This is an illustration of an anchor.
Figure 8 What reference points are you anchored to?

Anchoring is another key behavioural finance theory that affects financial decision making. Let us examine the roots of this theory.

The theory relates to the proposition that when people make decisions they utilise broadly consistent processes. These processes involve comparing the scenario in question with reference points stored in the memory or sourced from the immediate environment. These reference points can be based on personal past experiences of similar situations or on knowledge accumulated from other sources. Much of this processing happens in fractions of a second – something cognitive psychologists refer to as ‘quick and dirty’ or ‘good enough’ processing – and often without much conscious awareness.

In everyday situations, this really is a very effective, efficient and reliable process that commonly does indeed produce ‘good enough’ decision-making. The more experience people have of particular situations, the more proficient they tend to be in their decision-making. Whether this be a sport, profession or a simple task such as walking to work, the more experience gained of the task, the more reference points the memory will hold. Consequently decisions will become more consistent and less likely to be derailed by small variations in the tasks being assessed. For instance, on a regular journey to work, a person is unlikely to come to a standstill if they are faced with a road closure. Given the regularity of the journey sufficient reference points would have been built up to make a quick and ‘good enough’ decision about the best alternative route to take.

In the context of behavioural finance, anchoring refers to situations where the reference point or ‘anchor’ that is used to make a decision is not appropriate or relevant to the task in hand. This may arise through people having a tendency to anchor to things that they have recently been exposed to or to information that is readily to hand.

Kahneman and Tversky (1974) demonstrated people’s propensity to anchor to available information in several experiments. In one, they asked participants to focus on the last two digits of their social security numbers. They then asked them to bid on a variety of items such as chocolate, wine and computer equipment. Differences were recorded between the bids made by those with low numbers versus those with high numbers. Kahneman and Tversky found that participants with high numbers on their social security cards bid between 60 per cent and 120 per cent more for the items than those with low numbers.

Epley and Gilovich (2006) explain anchoring slightly differently: ‘One way to make judgments under uncertainty is to anchor on information that comes to mind and adjust until a plausible estimate is reached. This anchoring-and-adjustment heuristic is assumed to underlie many intuitive judgments, and insufficient adjustment is commonly invoked to explain judgmental biases.’

Anchoring is potentially the most common challenge affecting decision making. It is the most difficult to avoid because it is the basis of human decision making. However, it is not so much the process that is at fault, but rather the inappropriate reference points that become selected for particular decisions that can cause problems.

Anchoring and investment management

From an investment management perspective, anchoring can potentially impact at every level from individual decision making, through to the determination of a strategy for managing a portfolio. Challenges to effective investment management can arise from things such as failing to recognise changes in a market or sector by anchoring to traditional assumptions and past performances. Decision-makers may also anchor to the latest market trend, which may form a poor basis to predict future market movements.

An excellent recent example of anchoring that has caused major repercussions is how rating agencies, such as Moody’s and S&P’s, treated and rated certain financial products prior to the financial crisis at the end of the 2000s. For these agencies, the challenge was to apply the appropriate credit ratings to these complex products – many of which were relatively new to the financial markets. However, once a rating had been applied, this initial grading was then used as a benchmark or an ‘anchor’ for subsequent products. As the outcome from the financial crisis revealed, many of these products received a much higher rating than warranted by their intrinsic credit risks.

Anchoring is possibly the hardest behavioural bias to detect and filter out, as it is so closely related to the decision-making processes we rely on most heavily. However, it is possible for investors to allow for anchoring when measuring and monitoring the risks they are running with their portfolios. As part of strategic planning, key decision makers need to be challenged as to the quality and relevancy of the inputs they are using to make decisions.

Can you think of a piece of information that you have anchored to?