Before we start with today’s actual topic, let us first define the term “heuristic.” The term heuristic refers to a mental shortcut that helps people in quick decision-making and problem-solving. It is a rule of thumb that allows fast decision-making that makes people function efficiently and quickly without stopping and thinking for the next move.
We defined heuristic because it is what defines anchoring as well. This heuristic is a revelation from behavioral finance that uses irrelevant information like security purchase price subconsciously and anchors to make subconscious decisions about securities. Hence, people tend to create value estimation for the same item more if the sticker price is $150 compared to $100.
Anchoring makes a massive impact in areas like sales, price, and wage negotiations. In fact, many studies can attest to that. They show that an anchor used in a negotiation can impact the final results rather than interrupting the negotiation process. A deliberate starting point that is way too high can affect the range of all the subsequent counteroffers.
Tell me more about anchors.
Anchoring is a mind and intellectual activity that uses unusual benchmarks such as sticker prices. It puts an extreme weight in a person’s decision-making, just like mentioned earlier. In behavioral finance, this concept analyzes how a person’s unnecessary factors like our emotions play a part in economic decisions.
If we look at anchoring in an investing perspective, anchoring people can hold investments without value because of anchoring the fair value estimate to the initial price instead of the fundamental factors. These participants hold on to the idea that the securities in the investments they are holding will return to their purchase prices. Hence, they assume more significant risks. Even though these investors decide the way they do, they know that their anchors are far from perfect. So, they try to make adjustments that reflect subsequent information and analysis. But in the end, these adjustments will most likely lead to an outcome reflecting the initial anchor bias.
What is an anchoring bias?
Even analysts and traders may have anchoring biases that can lead them to terrible and hurtful financial decisions. For instance, others buy undervalued investments, and others sell overvalued assets. If financial decision-making is involved, there is always a massive chance of anchoring biases.
The usual anchors that we know include historical values and high-water marks. The reason for the hold is accomplishing a goal like a target return or raising net proceeds. Furthermore, these values are not even related to market pricing. But despite that fact, they can still affect market participants that make them disagree with opinions that make more sense. However, most analysts and traders will not encourage anchors like absolute historical values and values to achieve a goal because they can deteriorate investment objectives. Many other anchors can better help market participants with the challenge of an environment with overwhelming information.
In other situations, we can also encounter anchors on valuation multiples and other relative metrics. Some people use a rule of thumb valuation principle in evaluating security prices are also anchoring. They also disagree when a legitimate fact is already in front of them. When we say the rule of the thumb, we are only talking about those guidelines based on experiences and not theory.
Let us sum it up
Anchoring almost always comes with a heuristic, just like we mentioned earlier. A heuristic is also known as adjusting, and an anchor is also known as reference level. The anchors can adjust depending on the reevaluation of changing conditions and prices.