Wikipedia defines anchoring as – A cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions. Let us understand this with several examples.
UN Members and Wheel of fortune
In a study conducted by the psychologist Daniel Kahneman and Amos Tversky. A wheel of fortune was rigged in such a way that it will always stop at number 10 or 65. After the wheel displayed either of these numbers they asked the students of the University of Oregon to write down the number. After that, following questions were asked.
- Is the percentage of African nations among the UN members larger or smaller than the number you just wrote?
- What is your best guess of the percentage of African nations in the UN?
Do you think if the number displayed in the Wheel of Fortune had any effect? Here is the answer from the book Thinking Fast and Slow
The spin of a wheel of fortune – even one that is not rigged – cannot possibly yield useful information about anything, and the participants in our experiment should simply have ignored it. But they did not ignore it. The average estimates of those who saw 10 and 65 were 25% and 45% respectively.
Anchoring occurs when people consider a particular value for an unknown quantity before estimating the quantity. In the above example the anchor’s where either 10 or 65 and the percentage of African nations among the UN members is the unknown quantity.
Anchoring can be produced by 2 different mechanisms.
- Deliberate Adjustment.
Deliberate Adjustment is an act of System 2. What is System 2? Try to compute the value of 18 * 19. Whatever happened inside your head to solve this problem is an act of System 2. It needs to be brought into attention consciously or deliberately. Imagine you are driving in an highway at 70 mph and talking to your friends. You are taking the exit to drive in the city streets which has a speed limit of 30 mph. You will reduce your speed but you will not adjust enough. From the book Thinking Fast and Slow
Insufficient adjustment is a failure of a weak or lazy System 2. Start from an anchoring number, assess whether it is too high or too low, and gradually adjust your estimate by mentally moving from the anchor. The adjustment typically ends prematurely, because people stop when they are no longer certain that they should move farther.
Suggestion is a priming effect. It is caused by System 1. What is System 1? Listening to music is a System 1 activity. You should be able to do some other tasks along with that. Consider the following questions
- Was Gandhi more or less than 144 years old when he died?
- How old was Gandhi when he died?
Did you produce your estimate by adjusting down from 144? Probably Not. Still this absurdly high number influenced our estimates. How can that be? Watch the video – Malcolm Gladwell talks about priming
What about Professionals. Do they Anchor?
Yes they do. Real estate agents were asked to asses the value of the house that was in the market. They visited the house and studied a comprehensive booklet of information that included an asking price. Half the agents saw an asking price that was substantially lower and the other half saw a price that was substantially higher. What estimates did they come up with? Here is the answer from the book ‘Thinking Fast and Slow‘
They insisted that the listing price had no effect on their responses, but they were wrong; the anchoring effect was 41%. Indeed, the professionals were almost as susceptible to anchoring effects as business school students with no real-estate experience, whose anchoring index was 48%. The only difference between the two groups was that the students conceded that they were influenced by the anchor; while the professionals denied that influence.
Stock is cheap; selling 50% below the 52 week high
I used to analyze the stock in the following way.
- Look at the 52 week high price for the stock.
- Look at the current price.
- If the current price is selling way below the 52 week high price I consider it as a bargain
Why did I do that? I got anchored to the 52 week high price. Does it matter? No. It is an irrelevant piece of information. What matters is if the stock price is selling below its intrinsic value.
What does Warren Buffet do?
Buffett doesn’t look at the stock price when he’s evaluating a company. He reads the annual report of the company, understands the business and values it. Once the valuation is done he looks at the price. If it is selling below the value then he buys it. He does understand the effects of Anchoring.
Anchors at work
I am a software engineer. I get requests for estimating the scope of the project. The conversation will look something like this.
- Other – Will this project take 2 weeks?
- Me – No.
- Other – How long will this project take?
- Me – 3 weeks.
Did I really think? No, I got anchored with 2 weeks.
Keep in Mind
- Price paid is irrelevant information. The only useful information is the current value.
- If you are asked for an estimate, take time to think. Sleep over it. There is always tomorrow.