Anchoring and adjustment is a phenomenon wherein an individual base their initial ideas and responses on one point of information and makes changes driven by that starting point.
Anchoring is a cognitive error described by behavioral finance in which individuals fixate on a target number or value – usually, the first one they get, such as an expected price or economic forecast. Unlike the conservatism bias, which has similar effects but is based on how investors relate new information to old information, anchoring occurs when an individual makes new decisions based on the old, anchor number. Giving new information thorough consideration to determine its impact on the original forecast or opinion will help mitigate the effects of anchoring and adjustment.
Breaking Down Anchoring and Adjustment
The anchoring and adjustment heuristic describes cases in which a person uses a specific target number or value as a starting point, known as an anchor, and subsequently adjusts that information until an acceptable value is reached over time. Often, those adjustments are inadequate and remain too close to the original anchor.
One of the issues with adjustments is that they may be influenced by irrelevant information that the individual may be thinking about and drawing unfounded connections to the actual target value. For instance, an individual may be shown a random number, then asked an unrelated question that seeks an answer in the form of an estimated value or requires a mathematical equation to be performed quickly. Even though the random number they were shown has nothing to do with answer sought, it might be taken as a visual cue become an anchor for their responses. Anchor values can be self-generated, be the output of a pricing model or forecasting tool, or be suggested by an outside individual.
How Anchoring and Adjustment Are Implemented
An example of anchoring and adjustment is its use as a sales technique. A used car salesman (or any salesman) will often offer a very high price to start negotiations that is agreeably well above the fair value. Because the high price is an anchor, the final price will tend to be higher than if the car salesman had offered a fair or low price to start.
A similar technique may be applied in hiring negotiations when a hiring manager or prospective hire proposes an initial salary. Either party may then push the discussion to that starting point, hoping to reach an agreeable amount that was derived from the anchor.
In finance, the output of a pricing model or from an economic forecasting tool may become the anchor for an analyst.