1. Behavioral Finance: Introduction
  2. Behavioral Finance: Background
  3. Behavioral Finance: Anomalies
  4. Behavioral Finance: Key Concepts - Anchoring
  5. Behavioral Finance: Key Concepts - Mental Accounting
  6. Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
  7. Behavioral Finance: Key Concepts - Gambler's Fallacy
  8. Behavioral Finance: Key Concepts - Herd Behavior
  9. Behavioral Finance: Key Concepts - Overconfidence
  10. Behavioral Finance: Key Concepts - Overreaction and Availability Bias
  11. Behavioral Finance: Key Concepts - Prospect Theory
  12. Behavioral Finance: Conclusion

By Nathan Reiff

In the subsequent chapters, we’ll take a look at 8 key concepts that behavioral finance theorists have identified as contributing to irrational (and often detrimental) financial decision making. Chances are that you have fallen prey to one or more of these biases at some point in the past.

Anchoring

Just as a house ought to be built on a good, solid foundation, so too should our ideas and opinions be based on relevant, correct facts. Unfortunately, this is not always the case. The concept of “anchoring” refers to the tendency we have to attach (or “anchor”) our thoughts to a reference point—even though it may have no logical relevance to the decision at hand.

Anchoring may sound counterintuitive. Nonetheless, it is prevalent in many situations and particularly in those in which people are dealing with concepts that are new.

Diamond Anchor

One common example of “anchoring” is the conventional wisdom that a diamond engagement ring should cost about two months’ worth of salary. This “standard” is in fact an example of highly illogical anchoring. It’s true that spending two months of salary can serve as a benchmark when buying a diamond ring, it is completely arbitrary and irrelevant as a reference point. In fact, it may have been created by the jewelry industry in order to maximize profits.

Many individuals buying a ring cannot afford to spend two months of salary on this expense, on top of other necessary expenses. As a result, many people go into debt in order to meet the “standard.” In these cases, the diamond anchor can take on a new meaning as well, as the prospective ring buyer struggles to stay afloat in a sea of rising debt.

In theory, the amount of money spent on an engagement ring should be dictated by what a person can afford. In practice, though, many individuals anchor their decision on the irrational two-month standard, revealing the power of anchoring.

Academic Evidence

It’s true that the two-month standard in the diamond ring example above does sound relatively plausible. Nonetheless, academic studies have shown the anchoring effect to be so strong that it also takes place in situations where the anchor is completely arbitrary and random.

A 1974 paper by Kahneman and Tversky entitled “Judgment Under Uncertainty: Heuristics And Biases” shows the results of a study in which a wheel containing the numbers 1 through 100 was spun. Subsequently, subjects were asked whether the percentage of U.N. membership accounted for by African countries was higher or lower than the number on the wheel. Following that, the subjects were asked to provide an actual estimate of this figure. Tversky and Kahneman discovered that the random anchoring value of the number on which the wheel landed (which is completely unrelated to the question) nonetheless had an anchoring effect on the answer that the subjects gave. For instance, if the wheel landed on 10, the average estimate given by the subjects was 25%, while if the wheel landed on 60, the average estimate was 45%. In both instances, the random number on the wheel inadvertently drew subjects’ estimates closer to the number they were shown, in spite of the fact that it had absolutely nothing to do with the question at hand.

Investment Anchoring

Anchoring is a phenomenon that occurs in the financial world, too. Investors sometimes base their decisions on irrelevant figures and statistics. As an example, some investors invest in the stocks of companies that have dropped considerably over a short span of time. These investors are likely anchoring on a recent high point for the stock’s value, likely believing in some way that the drop in price suggests that there is an opportunity to buy the stock at a discounted rate.

While it’s true that the overall market may cause some stocks to drop significantly in value, thereby allowing investors to capitalize on short-term volatility, what is perhaps more likely is that a stock which has dropped in value in this way has seen a change in its underlying fundamentals.

For instance, imagine that XYZ stock had strong revenue over the past year, contributing to a share price rise from $25 to $80. In recent weeks, one of the company’s major customers, who contributed to 50% of XYZ’s revenue, decided not to renew its purchasing agreement with the company. As a result, XYZ’s share price drops from $80 to $40.

Investors who anchor to the previous high of $80 may erroneously believe that the stock is undervalued at $40. In this case, though, XYZ is not being sold at a discount; in fact, the drop in share value reflects a change in fundamentals (in this case, loss of revenue from a major customer). Investors who buy in at $40 believing the stock is valued at $80 are thus victims to the anchoring phenomenon.

Avoiding Anchoring

The best way to avoid anchoring in your investment practices is to engage in rigorous critical thinking. It’s best to be careful about the figures you utilize to evaluate a stock’s potential. The most successful investors don’t base their decision on just one or two benchmarks. Rather, they evaluate each company from a variety of perspectives in order to derive the truest picture of the investment landscape at hand.


Behavioral Finance: Key Concepts - Mental Accounting
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