Behavioral finance FAQ / Glossary (Anchoring)

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Dates of related message(s) in the Behavioral-Finance group (*):

Year/month, d: developed / discussed, i: incidental

(mental) Anchor / Anchoring

00/6i,8i,9i,11i- 01/5i,8i - 02/8i,11i - 03/3i,6i - 04/5i;7i - 06/11i

+ see adjustment, tunnel vision, dominant mental interest,

reference point, selection bias + bfdef2

Not bothering to look for several ideas, when the mind has already one in store.

Not bothering to navigate in the sea of numbers when cozily harbored in one.

Definition

Mental anchoring is a bias in which the mind stays focused on

only one simplified reference point, that is linked to a past data, situation,

experience, learning, reasoning, decision...

This single reference / anchor can be:

One single numerical value

A bias often found in economics and finance, as detailed in this article.

One set of facts, trait or information, (typical cognitive anchoring)

Often a past standard: past schema, practice, events, information or belief.

Also a past experience or solution / decision or analysis, related to a non

reproducible situation. In other words an obsolete heuristic (see that word)

One single idea / belief / mental interest. This can verge on monomania / fanaticism.

Or even one settled / stubborn emotion / attitude (liking or dislike):

here we have an affective anchoring.

Anchored with the eyes, with the brain or with the heart?

This reductive psychological phenomenon (an extreme form of heuristic, see that word) is also called

anchoring bias / focalism / focus effect...

As an exclusive mental reference, it hinders an objective and complete observation and

analysis to make decisions.

Normally (but not always) after a while, when it starts to prove unsustainable, an anchoring is followed

by a mental adjustment (see that word).

Effects of anchoring

Not easy to sail when the anchor gets stuck.

When the mind is anchored on a reference it tends to

solidify into a tunnel vision

be blind to signals that contradict that reference.

neglect facts and ideas that do not confirm this "prior", which often has no logical and objective basis.

The brain does not adjust (**) that reference

to new events, or it adjusts it only slightly.

(**) The phrase "anchoring and adjustment" is often used to stress

the opposition (and also continuity) between the two notions (see "adjustment").

It is one of the causes of underreaction (see that word) that can affect either an individual

or the whole collectivity ("dominant anchoring"), and have an effect on social events

Examples can be found in "stubborn" market evolutions, or also in political blindness

Anchoring in economic and finance

Anchored in a number.

Does that number means something ? Or is it drawn from a hat?

Economic and financial prospects (see "prospect theory") are areas in which the anchoring notion is mostly used

In those fields the "reference point" is most of the time a precise number, a value, a price.

In financial markets, investors are often anchored on a past asset price.

More specifically, in investment, the reference can be:

A previous peak stock (or index) price,

Or (quite often) the price

at which the asset was purchased.

Or a previous price trend,

Or a previous estimate,

Or also a round number,

Or even a "magical" number (see mysticism).

Whatever the facts or beliefs that led to that anchoring number, it has become a reference point of "value"

(see also prospect theory).

Mental anchors in investing are those reference values that people keep stubbornly in mind

and that keep influencing their decisions.

Origins of anchoring: the role of primacy / priming

The first one to take hold of the neuron keeps the neuron.

Those references can come from gradual learning.

But gradual learning is not the only source of anchoring,

it happens often that people create instantly their mental anchor

In such cases they base it on their first perception (primacy / priming effect) of things (or of people),

by seeing only what is for them the most salient information (see saliency) without waiting for enough data

Their mind gets stuck in their initial understanding whatever new data

they get later (see selection bias).

In finance, the initial price of the asset an investor bought stays obviously vivid in its mind.

A romantic remembrance of its first date with the asset.

What might also be an anchor is the estimate the investor had done from the start

about what price that asset would reach.

Why does the anchoring persist?

Committed? Stubborn? Or too lazy to reassess?

1) One way to explain that anchoring persist after the first perception is that people

could feel committed (see commitment) to their first move.

They prefer to rationalize (= find good reasons for) this commitment than to change their belief

(see cognitive dissonance).

2) Another motive of anchoring is that people can balk at the complex cognitive task that is needed

to reanalyze and adjust one's prior estimate of prospects and risks.

This reassessment would need to dig deep into various aspects such as:

What is the real incidence of the new events?

What flaws might have distorted the initial analysis?

Oversimplified perception (see availability heuristic) of the factors involved?

How to avoid such a myopic way to observe and analyze things in the future?

Investor anchoring

When the investment sea changes, why stay anchored in old waters?

Investors are often mentally anchored on past prices,

but also on past market situations, past estimates or past practices / strategies.

This has an incidence, as a brake or as an accelerator, on their behavior

1) Those investors stay anchored on a past reference, stick to some previous

over-simple or over-elaborate analysis / decision processes (*).

But the world, and specifically the financial world, is not static and the present state

of affairs usually differs, slightly or largely, from previous ones,

  Those investors, when facing those changes, at first tend to under-react,

by keeping more or less their same behavior (see also "status quo bias")

although it became inadequate.

Going to the disco with obsolete clothes

2) Later those investors adjust their attitude,

3) But they do not stop there, they tend after that to overreact

Thus their anchoring changes into a new one that takes into account more recent events

(see recency effect, short memory...).

(*) However useful you might find those thought habits, they have a "best before" date when to scrape them.

More seriously, look closely at their assumptions.

Between you and me, the old market assumptions, trends, practices and paradigms which become obsolete

might come back much later. Markets often evolve in spirals.

Negotiation reference

Starting blocks for haggling.

A business negotiation starts normally when one of the sides (seller or buyer) offers

- wisely or imprudently - a price, which becomes a kind of anchor.

A two-edged practice can be to propose at the start an unrealistic price. Here, two possibilities:

Either the counterpart immediately

runs away,

It considers it an insult,

This breaks any chance of making a deal.

Or often it becomes the reference point for haggling.

Here, the counterpart tends to under-adjust.

He ends up paying more (or get paid less) than what

he should have rationally got.

(*) To find those messages: reach that Behavioral-Finance group and, once you are there, 1) click "messages", 2) enter your query in "search archives".

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