Imagine you inherit a collection of old coins from your grandfather with a handwritten note saying they’re worth $1,000. A couple of years later you find yourself in a tight spot, and decide to sell the coins for cash. A collector offers you $500 for the set—and you promptly turn it down.
But say the collector instead offers you $1,250. You would happily agree to the sale, right? What if later you discover that the coins are worth at least $2,500? You’d be crushed, and instead of feeling like you’d made a good deal, you’d feel foolish knowing there was an opportunity to earn more.
This is an example of a psychological phenomenon known as anchoring bias, where individuals rely too heavily on the first piece of information they receive to make future decisions. In the hypothetical situation above, the note from your grandfather anchored your belief about the value of the coins, which in turn affected your choices about whether or not to sell them at a certain price. Anchoring bias can influence everything from real estate pricing1 to car purchases2 to salary negotiations.3
Anchoring is most pernicious when the first piece of information received has no relevance to the issue at hand. In one study, researchers asked participants to use their phone number as the basis for a reference date. Subjects were then asked if Attila the Hun was defeated in Europe before or after this calculated date. The researchers found a majority of participants’ responses to this question directly depended on the date they calculated based on their phone numbers—a completely unrelated factor.4
Even experts in the world of finance aren’t immune to anchoring bias. One study revealed that market analysts were more likely to make optimistic predictions when a firm’s forecast earnings per share were lower than the industry median, and pessimistic predictions when a firm’s forecast was higher than the median.5 Why? The analysts were anchoring on the industry norm for earnings, and assuming firms with low forecasts would have an easier time exceeding expectations, while those that set a higher bar were likelier to fall short.
Fighting anchoring bias
Anchoring itself isn’t necessarily a bad thing. However, you can run into problems if you use a poor anchor to make your judgements. Here are a few ways to use anchoring to your potential advantage.
- Acknowledge it: Ask yourself questions that may reveal anchoring behavior. If you’re trying to decide whether to sell or hold onto a stock, are you basing your choice on what you know right now about the company and the state of the market, or are you basing your target price on the purchase price or other measures that may be less relevant to the stock’s future course?
- Set your own anchor (and adjust as needed): Anchoring can be a beneficial tool as long as your established anchor is appropriate to your situation. It can be essential to set an anchor based on your personal needs and financial goals, modifying it as your circumstances change.
For example, one of the most important decisions in a person’s life is his or her expected retirement date. Anchoring your date based on when your neighbors retired isn’t the best idea because the sample size is too small and their situation may be completely different from yours. A better course of action is to look at the typical time employees leave the workplace, and then adjust based on your own situation.
The same concept is applicable to trading. While you can’t avoid losses entirely, you can manage them. Before you make an investment, decide how far you’re willing to let it fall, or how much you’d want it to gain, before you sell. Bracket orders and stop-loss orders are useful ways to set your own anchor. By placing a limit on both profits and losses, you can moderate the natural desire to leave your profitable positions too soon or keep your losing positions for too long.
And be sure to stay flexible. As you learn more, it’s reasonable to occasionally revisit your expectations and make sure they’re in line with what the market, your portfolio and your changing situation are telling you. Sometimes it’s worth taking a smaller gain than you wanted, rather than holding out hope for a price that never materializes.
- Consider history: Let’s say you’re trying to determine the future growth rate of the economy. A smart way to do this is to anchor on the historical growth rate for the country (say, 3%), then adjust your forecast up or down from that percentage based on how you believe future conditions are likely to deviate from historical conditions.
This can also be useful when trying to predict how much you’ll spend in retirement, for example. A good approach is to set an anchor based on how much you’re spending now, and then adjust that anchor based on how your lifestyle might change in retirement.
- Take advantage of objective resources when setting an anchor: Analyzing an underlying company’s fundamentals—by looking at its financial statements, management, competitors, expert analysis and other factors—will help you determine whether a particular stock is appropriate for your portfolio.
Schwab clients can access screeners for ETFs, mutual funds, and stocks, among other tools, to help find investments that are a suitable fit. And Schwab Equity Ratings® provide quantitatively-based assessments of individual stocks.
1Gregory B. Northcraft and Margaret A. Neale, “Experts, Amateurs, and Real Estate: An Anchoring-and-Adjustment Perspective on Property Pricing Decisions,” Organization of Behavior and Human Decision Processes, 1987.
2Thomas Mussweiler and Fritz Strack, “The Use of Category and Exemplar Knowledge in the Solution of Anchoring Tasks,” Journal of Personality and Social Psychology, 2000.
3Todd J. Thorsteinson, “Initiating Salary Discussions With an Extreme Request: Anchoring Effects on Initial Salary Offers,” Journal of Applied Social Psychology, July 2011.
4“Incorporating the Irrelevant: Anchors in Judgments of Belief and Value,” Heuristics and biases: The psychology of intuitive thought, New York: Cambridge University Press, 2002.
5Ling Cen, Gilles Hilary, and K.C. John Wei, “The Role of Anchoring Bias in the Equity Market: Evidence from Analysts’ Earnings Forecasts and Stock Returns,” Journal of Financial and Quantitative Analysis, 2013.
What You Can Do Next
- Listen to more episodes of Choiceology, a podcast about the psychological traps that lead to expensive mistakes.
- Do you trade frequently? Enroll in Schwab Trading Services and review your trading plan with a Schwab trading specialist.
- Need help planning for retirement? Consider Schwab Intelligent Portfolios PremiumTM, our unique approach that combines professional advice with automated investing.