Another common behavioral bias is the anchoring effect. Put simply, the anchoring effect describes the tendency to rely too heavily on a singular piece of data or information when making decisions. Often the anchor is an initial piece of information or something familiar to the decision maker. Taking the concept one step further, anchoring also describes how people consistently fail to appropriately adjust to new information because they are “anchored” to an initial reference point. Exploring how this behavior plays out in everyday life and when making investment decisions will help us better understand what it is as well as avoid some of its unpleasant consequences.
There are many examples of the anchoring effect at play. Two that most people regularly experience involve restaurants and gas stations. To illustrate how anchoring occurs at a restaurant, assume one dining party enters a crowded restaurant and is told the wait time is estimated to be 20 minutes while another party enters and is told the wait time is estimated to be 40 minutes. If both parties are seated after 30 minutes of waiting, it is very likely the party that waited a shorter amount than they were told will be in a much better mood than the other party, frustrated by having to wait ten more minutes than they were told. This is because we all subconsciously anchor ourselves to the initial data point, estimated wait time, and react according to how long we wait relative to that estimate. Thus, it is no surprise that some restaurants will intentionally overestimate actual wait times, creating a better dining experience for the customers.
Another real-world example of anchoring involves gas prices. The price of a gallon of gasoline is arguably the most recognizable of all prices. Each day, drivers see the price at the pump as they travel on America’s roads. What is less well known is how those daily data points affect their psychology. A motorist having to pay $3.00 per gallon for gasoline two weeks after paying $2.50 per gallon feels very differently than a motorist paying $3.00 per gallon two weeks after paying $3.50 per gallon. The first motorist, anchored to $2.50 per gallon, feels as though he is overpaying or wasting money while the second motorist, anchored to a higher price per gallon, feels as though she is getting a bargain. Yet both motorists are paying the same price.
ANCHORING AND INVESTING
What does this have to do with investing? Anchoring can unfortunately have negative effects on one’s investment portfolio and financial life. Three examples of investment- or financial-related anchors include becoming fixated on purchase price, targeting a random level in the market before investing, and using local housing prices to gauge the value on homes in other geographies. Briefly examining each of these examples can help investors overcome the urge to be overly influenced by these anchors when making important decisions.
When an investor purchases an investment, the purchase price, known as cost basis, is often crystallized in the investor’s mind. This becomes a natural anchor on subsequent decisions related to the investment. Cost basis can become a hurdle to overcome for any investment that has declined in value but needs to be sold. Sometimes there are fundamental or market forces that change the merits of holding the investment. Even though an investment declines in value, the projected forward returns on another opportunity may be much more attractive than waiting for the original investment to recoup its value. It is very difficult for investors to take a loss and move on or use the sale proceeds to purchase a more attractive investment. This same dynamic occurs with successful investments that are sold too early because an investor is similarly anchored to her cost basis and struggles to adjust to a potential new reality. The investor may fail to see how the investment can continue to provide attractive rates of return even when a positive inflection point occurs that changes the trajectory of the investment.
Another example of anchoring occurs when investors come into new money, such as an inheritance or sale of a business, and articulate a desire to “wait for a correction” before investing. This could refer to waiting for a 10% or 20% pullback in the stock market or simply be a round number they recall from the past, such as the Dow Jones Industrial Average falling to 20,000. The market may have recently increased, and there is a tendency to anchor one’s strategy to a lower market level that, at present, seems like a bargain. History reveals this line of thinking often results in sub-optimal outcomes as it is foolhardy to predict the market will inevitably return to previous levels. The last several years of strong market performance, when many were skeptical of stock valuations, is a great example of this. If investors are always waiting for the perfect time to invest, they might miss out on receiving dividends on stocks or interest income on bonds, a significant component of total return. Investors’ long time horizons tend to dramatically dampen the effects of bad timing. Finally, if individuals invest in a balanced, diversified portfolio that exhibits much less risk than stock markets, they are much less directly exposed to a correction than they may believe.
ANCHORING AND HOME OWNERSHIP
Outside of one’s marketable investment portfolio, market participants tend to view the nation’s housing landscape through the lens of their local market. It is easy to use familiar, local home values as an anchor when looking at second homes or house hunting during a relocation. The result can be sticker shock for someone moving to more expensive housing markets, such as the West Coast or Northeast. On the other hand, someone moving from a coast to the Midwest might have a hard time passing up a much bigger house with lots of land. Using your local knowledge of one area to decide what is a reasonable price to pay for a home in another market can result in a significant financial mistake. Homes are not easily tradeable, demographic trends vary greatly, local economies grow at different rates, income levels may be wildly different, and location matters. These dynamics make viewing housing prices through a narrow lens and anchored to one’s local market potentially costly.
The anchoring effect occurs daily for almost all of us. Most of the time, the subconscious tendency to rely too heavily on an initial piece of information simply results in fleeting elation, regret, or frustration. However, the anchoring effect can lead to material differences in future outcomes when it comes to one’s portfolio and financial life. Acknowledging its existence and examining how it may influence one’s decision making are key to avoiding anchoring’s negatives. One can seek to counteract the potential negative consequences of this behavioral bias by partnering with a strong team experienced in navigating these tendencies.