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Investors during trading journey are prone to many kind of investment bias. Behavioral finance explores the various kinds of human behavior that influence investment decisions. Among all the bias anchoring bias is quite common that occurs in many walks of life. So what is Anchoring Bias all about, let us understand in detail.
What is Anchoring Bias?
- This is a cognitive investment bias wherein people tend to rely on a specific piece of information to make a decision. To put it another way, people tend to consider one factor or detail above all others, thereby making the decision-making process biased towards or against that detail. This particular factor, which forms the core of the decision-making, is referred to as the anchor. Since the investor relies heavily on the anchor to determine whether or not a particular investment is a good choice for their investment portfolio, this kind of behavior is termed as anchoring bias.
- For example, while selecting a share, often investors check the 52-week high or low price. So, this initial information which registers in their mind is the anchor. Investors adjust the anchor price up or down, according to the information which they acquire further. In fact, the 52-week high price is an irrelevant number and often misleading. Because, compared to that price, the current market price may look cheaper, but still the share could be overvalued.
How does the anchoring bias work?
- Imagine you’re shopping for a new TV. The first one you see is at the original price of Rs 20,000. You move on and find another one for 15,000. Suddenly, the second TV seems like a steal, even though it’s still pricey. That’s the anchor bias effect in action, subtly shaping your perception of value. Another example related to trading is Let us assume that the stock market grew by 90% in 2024, closing at 15,200 points. It had closed at 8,000 points in 2023. Hence, investor Mr. Amit, looks into the above information and makes his trading decisions based on the market’s exponential growth
- However, trader Mr. A never realized that the stock market had only gained a miniscule 20% in 2023. Had Mr. A known the 2023 situation of the markets, the trader would not have relied only on 2023 performance. Thus, the trading decisions of Mr. A were skewed by anchoring bias where the stock market performance of 2023 served as the anchor. As a result, Mr. A suffered huge losses.
How does anchoring bias influence your investment patterns?
Anchoring bias can influence your investment patterns and keep you from making optimal decisions regarding your investment portfolio. More specifically, this investment bias can influence your patterns in the following ways.
1. It could make you ignore the fundamentals
When you anchor your focus on a specific detail alone, it becomes easy to ignore the fundamentals of the investment you are considering. In other words, you may tend to anchor the estimation of the fair value of a stock or any other asset to its market price rather than its fundamental markets. This may not be the best way to approach an investment decision.
2. You could make the wrong financial decisions
Anchoring bias could also encourage you to make financial decisions that are less than ideal. You could end up holding on to an overvalued asset for longer than ideal, owing to this investment bias. Alternatively, you may overlook an undervalued investment simply because you may have been fixated on its market price.
3. It could lead to other investment biases
Anchoring bias could also lead to other investment biases. For instance, it could easily make you fall prey to confirmation bias, which is the tendency to look for information and data that align with your preconceived notions. Anchors could also cause disposition bias, which is basically the behaviour of selling off shares whose price have increased, and holding on to the shares whose value has dropped.
How Does Anchoring Bias Affect Stock Traders?
Anchoring bias can have a number of negative consequences for stock traders. For example, it can lead to:
- Overpaying for stocks: If you are anchored to a high price for a stock, you may be more likely to buy it at a higher price than it is actually worth.
- Selling stocks too early: If you are anchored to a low price for a stock, you may be more likely to sell it too early, before it has had a chance to recover.
- Making poor investment decisions: Anchoring bias can lead to you making poor investment decisions, as you may be influenced by irrelevant information.
How to Overcome Anchoring Bias
- It is advisable for investors to practise critical thinking to avoid anchoring bias. Critical thinking in this context means that when everyone around you is getting all positive news about a share or industry, you must try to find out negative points in it as well. Such thinking will provide investors a broader view of the entire scenario.
- Similarly, analyst forecast /expert opinion about any particular industry or company makes investors anchored to their information, which may not be correct. In such scenarios one should do a thorough research on their own before investing their hard-earned money. Similarly, when the price of the shares in your portfolio goes up or down, to avoid price anchoring, you must check the company fundamentals before making a call to sell or buy.
- The easiest way to overcome the anchoring bias is to track one’s behavior and identify the anchors that you are normally prone to be dragged down by. Objectivity and a practical approach to investing can go a long way in helping you to be away from anchors that influence your investment pattern and thus affect your portfolio returns negatively. By means of practice and over a period of time, one might get better at avoiding this investment bias.
Conclusion
Anchoring bias is a common cognitive bias that can have a negative impact on stock traders. By being aware of anchoring bias and taking steps to overcome it, you can improve your investment decision-making and make better returns on your investments.
