As individuals, investors are no doubt often prone to many kinds of investment bias. Behavioral finance explores the various kinds of human behaviors that can influence investment decisions. Among the many types of bias that often come into play when you’re setting up your investment portfolio, anchoring bias is quite common. In fact, anchoring bias occurs in many walks of life, including the negotiations you make, the sales and marketing techniques that companies employ, and even in regular, everyday decisions.
Let’s get to know what anchoring bias is and find out how it influences your investment patterns.
What is anchoring bias?
With regard to finance, 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.
Anchoring bias: An example
Let’s take a look at an everyday example of anchoring bias. Say you’re shopping online for a pair of boots. The first pair you chance upon online costs about Rs. 7,000. You consider it overpriced, so you keep looking for more affordable alternatives. And then, you find a pair that costs around Rs. 5,000. Comparing it to the earlier pair, you find that this one is cheaper, so you make your purchase. Later, however, you discover that there are many more affordable options, some even priced as low as Rs. 2,000.
In this case, the Rs. 7,000-pair was your anchor. You made your comparison based on that price, and anything that was relatively cheaper was a better option, or so you thought. This is clearly a case of anchoring bias keeping you from making the best decision possible. Had you not been anchored on the Rs. 7,000 price tag, you may have been able to make a more budgeted purchase decision.
Anchoring can also feature as an investment bias, particularly when investors are looking at the stock market. The stock price is often the first thing that investors look at before adding a stock to their investment portfolio. Factors like historical price and fundamentals are only considered after they look into the stock price. This invariably makes all their expectations anchor heavily on the price of the stock. For instance, say you’re looking to increase the equity exposure in your investment portfolio. And say you decide to buy stocks from some of the top-performing pharma companies. One company’s stock is priced at Rs. 52 in the market, while another company’s stock is priced at Rs. 1,176. If you make the mistake of anchoring your decisions to the stock price, you could end up buying the Rs. 52 stocks even though the fundamentals of the other company may be stronger.
Here’s another example of anchoring bias at play. On January 6th, 2021, Nifty clocked a gain of 87.17% from its March 23 low of 7,610. You may look at this bit of information and make a trading decision, not realizing that in the calendar year 2020, the Nifty climbed 14.90% only. This effectively means you’ve anchored your decision on the lows of March 2020.
Additional Read: Behavioural biases in investing that you should be wary of
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 behavior of selling off shares whose price have increased, and holding on to the shares whose value has dropped.
Additional Read: 5 behavioural biases that can affect your investment decisions
The best way to overcome the anchoring bias is to actively track your behavior and identify the anchors that you are prone to be dragged down by. Objectivity and a practical approach to investing can go a long way in helping you steer clear of anchors that influence your investment patterns adversely. It takes some practice, but with time, you get better at avoiding this investment bias.
Wealth managers at Tata Capital Wealth who are experienced professionals understand these biases. They can help you in your quest for steady and healthy returns on your investment portfolio.