What is Anchoring and Adjustment?
Anchoring and adjustment involve 2 steps, the first being anchoring – the fixation on a certain idea or response. Then, changes are made based on that original starting point – known as adjustment.
It is essential that our knowledge is based on a solid foundation. Anchoring is our brain’s way of finding a reference point to hold onto. It is, of course, convenient to build new thoughts and ideas from preexisting beliefs and premises.
This is, after all, the way in which children first learn to understand new concepts. They create schemas for common concepts like four-legged animals, then gradually learn to differentiate between the many subsets of this schema, like dogs or cats.
However, the belief we choose as our anchor point can hold incredible sway. A study had its subjects guess which percentage of UN membership was made up of African countries. Participants were told whether or not a random number given by a wheel labeled 1 to 100 was higher or lower than the true percentage, then were asked to make their own guess. The results revealed that when the wheel landed on 10, the average guess was 25%, while the average estimate was 45% when the wheel landed on 60.
In this case, there was a huge percentage differs depending on which number the wheel pointed to. Participants largely stayed within the range of the random number.
One major lesson to take away from this study is that even though the anchor points were completely random and therefore incredible, the subjects took these random numbers as foundations for their own guesses.
Anchoring and Adjusting in Investing
As instanced by the aforementioned study, individuals have the tendency to hold onto an arbitrary piece of information and view it as an anchor point. This behavioral quirk can have serious consequences in the financial world.
Anchoring is especially risky for first-time investors, who may religiously follow misconceptions. However, more seasoned investors can also fall into the clutches of anchoring and adjustment. For instance, some investors may anchor on a high point for a stock (say, $50). When the stock price falls to $30, they may erroneously believe that the stock is being undervalued when in fact this new price is based on a true and fundamental change in the market. These investors would believe that the true value of the stock is $50 and eagerly buy up the stock at the “low” and “discounted” price of $30.
Anchoring and adjustment is an unconscious behavioral tendency. Therefore, the best way to counteract this phenomenon is to engage in critical thinking. Make sure to thoroughly read and analyze many different sources to ensure that you can make an informed decision. Avoid mental shortcuts.
Do you have any other tips? How do you deal with anchoring and adjustment?
Want more brain food? Learn more about Behaviorism and how it affects us when investing.