Continuing our theme of behavioural economics, this week we look at anchoring? Anchoring is how people can be mislead into thinking they have bagged a bargain. It also tricks people into selling good investments and keeping bad ones.
Here is an idea for you. There is no such thing as a discount. There is just the price.
As we head into Christmas, many people will be lured into retailers with the promise of discounts or price reductions. Many people can’t resist the potential for a bargain – a sign promising 30% off is simply impossible to ignore!
Often, these people are giving in to a cognitive bias called anchoring. Anchoring is where people take an initial piece of information and use it as the foundation (or the anchor) against which they assess all future information. People can’t get the first piece of information out of their head – which is why retailers publish an initial higher price before offering a ‘discount.’ The discount looks like a significant reduction in the price, and tricks a purchaser into thinking that they have bought something cheaply.
So, if an article was ‘originally’ advertised at $100, but I bought it for $70, I walk out of the shop thinking that I have saved $30. I haven’t. I’ve just spent $70. But the retailer anchored me at a higher price.
We see anchors at work in investment markets as well. Auctioneers are notorious for it. “This property is easily worth $1 million. But we will open the bidding at $650,000. Can I have an offer of $50,000 above this?” And on it goes, with the auctioneer seeking to anchor and re-anchor people’s bidding as the auction progresses.
And then there is the sharemarket. Most people anchor their thoughts about sharemarket investments to the purchase price paid for that investment. So, if shares are purchased for $10, this becomes the anchor for all future decisions about that share. This can become a problem. For example, if the value of the shares falls to $8 while you are holding it, then the fact that you bought it for $10 is now immaterial. You need to make your decisions based on whether it is worth selling the share for $8. But most people will find it hard to ignore that selling the share for $8 will crystallise a loss of $2. Their thoughts are anchored on the $10 purchase price. Lots of people hang on to a share until they ‘get their money back.’ Unfortunately, sometimes this becomes a long wait.
This is actually another cognitive bias – loss aversion. It causes many people to hang on to shares that have fallen in value. What’s more, we often see people sell shares that have risen in value. If the $10 share rises in value to $12, then the investor can be tempted to sell and realise a $2 gain. What the investor needs to do is decide whether the share is now worth more than $12 if they keep it.
The point is the same: people need to re-anchor their thoughts about a share’s value every day they hold that share. But most people anchor a first time and leave it at that. That’s why history shows that people tend to be too keen to sell shares that have risen in value and keep shares that have fallen in value.
So, how do you overcome anchoring? Simple: remind yourself – there is no such thing as a discount. There is just the price that you agree to pay.
And when it comes to investing: yesterday’s losses and gains are immaterial. Today, we just have the current price and an investment’s future prospects. Assess everything against that.