Anchoring is a cognitive bias that was first documented by psychologists in the early 1970s. Anchoring occurs when people need to form estimates. In doing so, people tend to start off with an initial value, and then adjust away from it. However, often the adjustment away from the initial value is insufficient. In other words, people tend to ‘anchor‘ too much on the initial value.
As an example, let’s discuss an experiment that was actually used to establish the existence of anchoring. During the experiment, participants were asked to estimate the fraction of United Nations’ countries that are African. However, before participants were asked to answer this particular question, they were first given a random number (between 0 and 100). The participants first needed to answer whether their guess was higher or lower than this random number.
What the researchers found was that subjects’ subsequent estimates were affected by the initial random number that the researchers ‘suggested’ them. In particular, participants who drew the random number 10, estimated the fraction of African countries to be only 25%. Those who drew the number 60, estimated the fraction of African countries to be 45%. Hence, although the random number was irrelevant, it had an influence on the participants’ estimates.
Anchoring can lead to bad investment decisions in finance. For example, some investors tend to invest in companies whose stock prices have dropped considerably in a very short period of time. In such instances, investors tend to anchor on the recent ‘high’ of the stock price and wrongly believe that the recent drop provides them an opportunity to buy the stock at a discount.
Anchoring is probably also related to the so-called ‘post-earnings-announcement drift‘. This is a phenomenon in stock markets where the price of a company’s stock underreacts to new information on the company’s earnings. Instead of fully reflecting the new information immediately, the stock price instead drifts to the new fundamental value. In this case, the past stock price acts as an anchor.
Anchoring is related to the disposition effect. In this case, investors anchor to the purchase price of the stock.
When making a prediction or guess, we have start somewhere. However, our initial guess tends to have an enourmous influence on our estimate.