Anchoring/Disposition Effect

Anchoring

Anchoring occurs when people make estimates based off an initial value. When the value is introduced, we use it as a reference point and make adjustments off of it. The initial value serves as an anchor. If the anchor value is inaccurate, our adjustments may not be sufficient to arrive at an accurate estimate or a reasonable financial transaction.

Example

Drazen Prelec and Dan Ariely conducted an experiment at MIT in 2006 where they had students bid on items in an auction. Ariely explains in his book, Predictably Irrational, that the researchers would hold up a bottle of wine, a textbook, or a cordless trackball and then describe in detail how great it was. Then each student had to write down the last two digits of their social security number as if it was the price of the item. If the last two digits were 11, then the bottle of wine was worth $11. If the two numbers were 88, the cordless trackball was worth $88. After they wrote down the pretend price, they bid.  As expected, the anchoring effect scrambled their ability to accurately judge the value of the items. People with high social security numbers paid up to 346% more than those with low numbers. Those with numbers from 80 to 99 paid on average $26 for the trackball, while those with 00 to 19 paid around $9.

Social security numbers were the anchor in this experiment only because we requested them. We could have just as well asked for the current temperature or the manufacturer’s suggested retail price. Any question, in fact, would have created the anchor. Does that seem rational? Of course not.

– Dan Ariely from his book, “Predictably Irrational”

Financial Implications

Anchoring can lead to poor investment decisions. For example, an investor might be tempted to invest in a company whose stock price just dropped considerably, thinking that it represents a discount, when it simply reflects the company’s diminished future prospects. Alternatively, an investor may be inclined to sell an investment whose price has increased dramatically. The purchase price becomes an anchoring point instead of considering new information and the future growth prospects of the investment. This type of thinking is also closely tied to the disposition effect, which is defined below.

One scenario that anchoring can provide an advantage with is in negotiations. Beginning with an artificially high or low figure (depending on what you want) will set the terms of a negotiation. Applications of such a tactic include buying a car, negotiating a salary, or purchasing a home.

Disposition effect

Investors tend to hold on to losers, but sell winners. Why? The most likely explanation is based on our desire to avoid admitting mistakes and feed our ego. Selling a poor investment is a tacit acknowledgement of an error in judgement. Conversely, selling an investment that has performed well is a mental victory lap. Unfortunately, anchoring to the original purchase price and falling prey to these biases have real world consequences. Studies have found that holding onto winners (stocks that perform well) and quickly selling losers, leads to better performance over time due to momentum factors.

Ultimately, anchoring is one of our most powerful cognitive biases, and can only be partially mitigated by our own self-awareness. Disposition effect is more easily addressed. Sell your poorly performing investments and hold onto your winners.

^{This is not a recommendation and is not intended to be taken as a recommendation. This material was prepared for general distribution and is not directed to a specific individual.}

^{LPWM LLC does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers.}