You might be considering buying a new car. You might even have envisioned yourself at the wheel of that swanky new BMW with gesture-control HoloActive Touch technology; that is, until you saw the outrageously preclusive price in Consumer Reports.
But later you noticed the same model at a discount, and that shiny black leather-encased steering wheel now suddenly seems within your grasp.
This rationalizing process is an example of “anchoring,” what psychologists describe as the tendency to rely on the first piece of information offered. In the case of the BMW, the initial conceived price sets the bar and, when a lower price is found, the original price can seem like a great deal, even if it is considerably high.
Marketers are well aware of the anchoring phenomenon, and the information that consumers receive is often designed to exploit the anchoring effect and encourage consumer purchases.
Take the wine menu at a high-end restaurant. The first few bottles of wine listed may have a high price tag, $100 or more. Compared to the $100 bottle, the $60 bottle listed a bit further down on the wine list seems like less of an indulgence, even though a $25-dollar bottle is more in your price range.
Anchoring: Part of the Human Condition
Kahneman and Tversky coined the term “anchoring” in the 1970s. They researched how people formed judgments when they are unsure of the facts. They found that when people are uncertain, they make assumptions using the most recent number they see as a starting point. And what’s more uncertain than speculating on the stock market?
Here are some ways to manage anchoring tendencies when making investment decisions and when contemplating other purchases.
Anchoring and its Danger for Investors
Anchoring is particularly unwise when it comes to investing because stock price is not a good indicator of a company’s value. Nevertheless, when a stock price is viewed by a potential investor, that price can serve as an anchor and influence perceptions of the value of that stock and other stock.
But this type of influence makes no sense when markets are constantly changing, and there are so many factors affecting the price of a stock.
Be Aware of Anchors
Accept that you are influenced by anchors and try to identify their affects. Anchoring is often exacerbated by other behaviors such as relying on hindsight, overconfidence, and attempting to create a narrative to justify a forecast, which just amounts to noise.
Don’t cling to an illogical or irrelevant anchor. For example, if a report predicts that a price for a commodity will triple three years from now, don’t ignore a falling price in year two in the hopes that the price will triple in year three. Recognize a losing investment and cut your losses.
Historical Prices Are Irrelevant
An investor might notice that a stock has dropped rapidly in a short period and seize the chance to buy low. This investor is “anchoring” the decision on a recent price that the investor believes was high and a belief that the stock is now undervalued, which may not be the case. There are many variables that might determine whether that stock price will ever recover.
Anchor to Something with Predictive Power
Stock prices are simply the latest estimated value of a company, not its real value. It is better to anchor to something that can be predicted, income from dividends for example, as in the Gordon Growth Model. A quality investment strategy identifies stock that reflects less debt and stable earnings.
Income from earnings are not susceptible to accounting treatments and represent reliable information. Studies have shown that bubbles are more likely when investors don’t use dividends as an anchor. Dividends and dividend yields are a better reflection of price relative to value.
There are many variables affecting the price of stock. Don’t base your decisions on one or two factors; instead, research companies and gain as much information as you can before investing.
The best way to avoid anchoring is to ignore the stock price level altogether, make regular investments, and hold investments for a planned timeframe so that earnings average out over time.
Being aware of the effect of anchoring can bring perspective to your buying decisions. So, next time you are out to dinner and the sommelier cheerily points to the 1988 Robert Mondavi Reserve Cabernet, remember the anchor effect … and order it anyway.