Anchoring Bias: Understanding How First Impressions Influence Decisions

Anchoring bias occurs when people rely too much on pre-existing information or the first information they find when making decisions. For example, if you first see a T-shirt that costs $1,200 – then see a second one that costs $100 – you’re prone to see the second shirt as cheap. Whereas, if you’d merely seen the second shirt, priced at $100, you’d probably not view it as cheap. The anchor – the first price that you saw – unduly influenced your opinion. Anchoring bias is an important concept in behavioral financeBehavioral FinanceBehavioral finance is the study of the influence of psychology on the behavior of investors or financial practitioners. It also includes the subsequent effects on the markets. It focuses on the fact that investors are not always rational.

Anchoring Bias Example in Finance

If I were to ask you where you think Apple’s stock will be in three months, how would you approach it? Many people would first say, “Okay, where’s the stock today?” Then, based on where the stock is today, they will make an assumption about where it’s going to be in three months. That’s a form of anchoring bias. We’re starting with a price today, and we’re building our sense of value based on that anchor.

Learn more in CFI’s Behavioral Finance Course.

Anchoring in Public Markets

Anchoring bias is dangerous yet prolific in the markets. Anchoring, or rather the degree of anchoring, is going to be heavily determined by how salient the anchor is. The more relevant the anchor seems, the more people tend to cling to it. Also, the more difficult it is to value something, the more we tend to rely on anchors.

So when we think about currency values, which are intrinsically hard to value, anchors often get involved. The problem with anchors is that they don’t necessarily reflect intrinsic valueIntrinsic ValueThe intrinsic value of a business (or any investment security) is the present value of all expected future cash flows, discounted at the appropriate discount rate. Unlike relative forms of valuation that look at comparable companies, intrinsic valuation looks only at the inherent value of a business on its own.. We can develop the tendency to focus on the anchor rather than the intrinsic value.

Avoiding Anchoring Bias

So, how do you guard against an anchoring bias? There’s no substitute for rigorous critical thinking. When you approach evaluation, instead of looking at where a stock is now, why not build up a first principles evaluation using DCFWalk me through a DCFThe question, walk me Through a DCF analysis is common in investment banking interviews. Learn how to ace the question with CFI's detailed answer guide. analysis? When analysts find their evaluation is far out from the actual stock price, they often try to change their evaluation to match the market. Why? Because they’re being influenced by the anchor instead of trusting their own due diligenceDue DiligenceDue diligence is a process of verification, investigation, or audit of a potential deal or investment opportunity to confirm all relevant facts and financial information, and to verify anything else that was brought up during an M&A deal or investment process.  Due diligence is completed before a deal closes..

More reading: Not All Anchors Are Created Equal.

Additional Resources

Thank you for reading CFI’s guide to understanding how anchoring bias works. To learn more, check out CFI’s Behavioral Finance Course. Additional relevant resources include:

• Behavioral Finance GlossaryBehavioral Finance GlossaryThis behavioral finance glossary includes Anchoring bias, Confirmation bias, Framing bias, Herding bias, Hindsight bias, Illusion of control
• Loss Aversion BiasLoss AversionLoss aversion is a tendency in behavioral finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains. The more one experiences losses, the more likely they are to become prone to loss aversion.
• Framing BiasFraming BiasFraming bias occurs when people make a decision based on the way the information is presented, as opposed to just on the facts themselves. The same facts presented in two different ways can lead to different judgments or decisions from people.
• Narrative FallacyNarrative FallacyOne of the limits to our ability to evaluate information objectively is what’s called the narrative fallacy. We love stories and we let our preference for a good story cloud the facts and our ability to make rational decisions. This is an important concept in behavioral finance.