Anchoring and Adjustment Bias

Anchoring
When required to estimate a value with unknown
magnitude, people generally begin by envisioning some
initial, default number an anchor-which they then
adjust up or down to reflect subsequent information and
analysis.
The anchor, once fine tuned and reassessed, matures
into a final estimate.
Numerous studies demonstrate that regardless of how
the initial anchors were chosen, people tend to adjust
their
anchors
insufficiently
and
produce
end
approximations that are, consequently , biased.

Anchoring
Investors tend to make general market forecasts
that are too close to current levels.
For example, if the DJIA is at 10,500, investors are
likely to forecast the index in a way narrower than
what might be suggested by historical fluctuation.
The investor subject to anchoring might forecast
the DJIA to fall between 10,000 and 11,000 at the
year end rather than making an absolute estimate
based on historical standard deviation (rational)
analysis.

Anchoring
Investors (and security analysts) tend to stick too
closely to their original estimates when new
information is learned about a company.
For example, if an investor determines that next
years earnings estimate is $2.00 per share and
the company subsequently falters, the investor
may not readjust the $2.00 figure enough to
reflect the change because he is anchored to the
figure of $2.00

Anchoring
Investors tend to make a forecast of the
percentage that a particular asset class might
rise or fall based on the current level of returns.
For example, if the DJIA returned 10 percent last
year, investors will be anchored on this number
when making a forecast about next year.

Anchoring
Investors can become anchored on the economic
states of certain countries or companies.
For example, in the 1980s, Japan was an economic
powerhouse, and many investors believed that they
would remain so for decades.
Unfortunately for some, Japan stagnated for years
after the late 1980s.
Similarly, IBM was a bellwether stock for decades.
Some investors became anchored to the idea that
IBM would always be a bellwether.
Unfortunately for some, IBM did not last as a
bellwether stock

Anchoring: Example
An investor invests in a stock at $12. It currently
trades at $15. A few months back, the stock
touched $20. The investor contemplated selling at
that price but could not. The stock then fell to $15
on market perception of faulty accounting practices
by the company.
The investor feels as though he has lost 25 percent
of the stocks value.
He would prefer to wait and sell his shares when
the stock returns to its recent $20 high.
Some research by the investor reveals faulty
methods adopted by the company.

Anchoring: Example
The investor cannot entirely gauge the depth of the problem
and realizes that holding the stock is risky, but the company is
also a viable corporate entity with good prospects.
A rational investor would examine the companys financial
situation; make an objective assessment of its business
fundamentals; and then decide to buy, sell or hold the shares.
Conversely, some irrational investors-even after going through
the trouble of performing the aforementioned rational analysis
permit cognitive errors to cloud their judgment.
The investor in the present case may irrationally disregard the
results of his research and anchor himself to the $20 figure,
refusing to sell unless the stock once again achieves that price.
This type of response reflects an irrational behavioral bias and
should be avoided.

Anchoring: Research
A study done by Northcraft and Neale (1987) asked a group of
real estate professionals to value a property.
The real estate agents were divided into two groups. Each group
received a guided tour of the home, a 10-page information packet
describing the home, and a list price of the property.
The list price given to one group was $117,745 and to the other
was $130,981.
The groups were asked, among other things, to provide the value
of the property should it be put up for sale.
The first group gave the asking price of $119,900 while the
second
group
gave
the
asking
price
of
$149,900

Anchoring: Research
There was a clear evidence of anchoring
price led to higher asking price estimates.

as the higher list

The appraisals did not necessarily reflect the objective

characteristics of the property.
Rather, they were influenced by the initial values on which the
agents anchored their estimates.
The study clearly demonstrated that anchoring is a very
common bias, applying to many areas of business and finance
decision making.
Investors and wealth management practitioners need to be
keenly aware of this behavior and its effects.

Anchoring: Example
A person wants to sell a house he purchased 15 years
ago for $250,000.
A real estate agent prices the home at $900,000.
The investor places the house on the market but does
not receive any inquiries for some months.
One day, the real estate agent informs him that local
real estate prices have declined by 10 percent across
the board. This has happened a long-standing company
in the area had gone bankrupt rendering a large number
of people in the area jobless.
The real estate agent asks the person to decide the price
at which he wants to list his home, based on this new
information.

Anchoring: Example
If the person wants to sell his house, he must lower
the price by 10 percent.
Resistance to adjust the price would indicate
anchoring to the figure of $900,000.
The anchoring effect stems from the failure to
incorporate new information that real estate prices
have declined by 10 percent.
This behavior can have significant impact in the
investment arena and should be guarded against.

Anchoring: Advantages
Anchoring and adjustment bias has a positive side
also and can be exploited to ones advantage.
Understanding anchoring and adjustment can be a
powerful asset when negotiating.
Many negotiation experts suggest that the
participants communicate radically strict initial
positions, arguing that an opponent subject to
anchoring can be influenced even when the anchor
values are extreme.

Anchoring: Advice
From the investment perspective, awareness is the best countermeasure to anchoring and adjustment bias.
When you are advising clients on the sale of a security, encourage
clients to ask themselves: Am I analyzing the situation rationally,
or am I holding out to attain an anchored price?
When making forecasts about the direction or magnitude of
markets or individual securities, ask yourself: Is my estimate
rational or am I anchored to the last years performance figures?
Asking these questions can root out any anchoring and adjustment
bias that might be present during asset sales or asset

Anchoring: Advice
When considering a recommendation
by a securities
analyst, delve further into research and ask yourself: Is
this analyst anchored to some previous estimate, or is the
analyst putting forth an objective rational response to a
change in a companys business fundamentals?
Securities analysts are not immune from the effects of
anchoring and adjustment bias.
An investment strategy can leverage this behavior of
securities analysts. The strategy takes advantage of the
tendency
exhibited
by
securities
analysts
to
underestimate, both positively and negatively, the
magnitudes of earnings fluctuations due to anchoring and
adjustment bias.