Most of us like to think that we’re entirely in control of our own decisions. However, we’re all actually being swayed by… anchors!?
Shares in both Amazon and Alphabet crossed the $1000 threshold over the past year, putting both companies into a small group of S&P 500 companies to do so.
So how much do you think a share in Apple currently costs?
…Ok, if you’re a shareholder in Apple, or planning to become one very soon, you could probably tell me straight away.
But if you’re not, I’m willing to bet that—even if it was just for a second—a number popped into your head when you read that question. I’m also willing to bet that it was in the ballpark of $1000, maybe slightly lower.
What does that mean? Well, it means that you, like almost every other human on the planet, suffers from a psychological bias called the anchoring effect.
The Anchoring Effect
The first real study of the anchoring effect and how it influences us was carried out by Daniel Kahneman and Amos Tversky, two psychologists working during the 1970s.
The anchoring effect, as defined by Kahneman in his book ‘Thinking, Fast and Slow’, occurs ‘when people consider a particular value for an unknown quantity before estimating that quantity.’
In other words, it’s a trick our brain plays on us when we are asked to estimate a number or value for something that we don’t really know the answer to. If we can’t come up with the solution straight away, our brain immediately searches for any information that sounds remotely like the answer.
So in the case above, if you didn’t know the current share price of Apple (about $175 by the way), your brain will automatically recall that you recently heard that both Amazon and Alphabet have a share price of around $1000. Considering that they’re all companies that are roughly the same size and in similar industries, you naturally—and incorrectly—estimate the answer.
It can be even more abstract than this, however.
Take this actual experiment which is referenced in Kahneman’s book.
At the University of Oregon, a wheel of fortune was set in front of a group of students. The wheel was marked from 0–100 but was actually rigged (unbeknownst to the students) to stop at either 10 or 65 every time.
The students were asked to spin the wheel, and were then asked: ‘What is your best guess of the percentage of African nations in the UN?’
It’s a tough question and one that you wouldn’t really expect a lot of U.S students to know. And, of course, the number that they had just seen on the wheel of fortune (either 10 or 65) obviously gave them no indication of the correct answer.
However, the answers were unequivocally influenced by the numbers seen on the wheel. The average answer for those who had seen 10 on the wheel of fortune was 25%, while those who had seen 65 answered 45%.
The student response to this question had been completely skewed by a number unrelated to the true answer. They didn’t know the answer to the question, so they then subconsciously recalled the last number they had seen and based their answer off that.
So why do we do this?
We’re intelligent creatures, we understand more about the brain now than we ever have before. How are we so susceptible to such a biological bug?
Dave McRaney (who we’ve mentioned before) asserts that we depend on anchors every single day in pretty much every mental task we perform. Anchors are something we mentally compare against, a benchmark we unconsciously set in order to figure out if we’re doing a good job or paying too much.
Take some of the bills you pay regularly for example. You might pay $9.99 per month for Netflix, which then becomes an anchor in your mind. You know that if you pay less for another streaming service, you’re probably getting a great deal. If you’re paying more, then you better be getting a significantly better service or you’ll consider yourself ripped off.
What about if you’re buying or renting a house in a new city. Once you’ve viewed a few of them, you’ll have created an unconscious anchor of what you’ll expect to be paying, and you’ll find that any price you get below that—even if it’s marginal—will be an internal success. Of course, the prices set on these properties were likely set by someone under the influence of an anchor themselves. Hello, property bubble!
Really, it’s just the process of your mind trying to get a foothold from where you can then base your decision. If it’s an area you’ve some expertise in, you’ll base your benchmark on past information stored in your brain.
If it’s something you’re completely new to though, you’re likely—just like those students in Oregon—to base your decision on completely irrelevant information.
So what do I do?
Interestingly, the anchoring effect shows us how premium brands manage to charge customers so much for their products. Companies like Tiffany and Apple can charge extra because consumers have an internal anchor implanted in their mind about these products. These are premium brands, they are worth this much. As McRaney notes, if ‘Wal-Mart offered a purse at $800, it would live out its life on the shelf.’
In terms of the stock market, investors can often become anchored on price. Say a certain stock was trading at $100, and then suddenly dropped to $70 over the course of a day. It’s easy to become anchored to the higher share price the stock was trading at and believe that the share ‘belongs’ to that price in some way. If you start thinking this, then you would consider the $70 stock a bargain and invest heavily.
However, it could have been a case of an overpriced stock correcting itself, and there are no guarantees that it will ever return to the higher share price again.
If nothing else though, an awareness of the anchoring effect shows you the importance of taking the time to fully research any major decision you make.
You’d be surprised at the amount of evidence which proves how anyone can be affected by anchors far more than they think. Kahneman references a worrying example where a group of judges, whom most would consider the epitome of impartiality, were proven to alter the sentencing of similar crimes based on the number shown by the roll of a dice!
It’s not particularly a case of examining every single thing you do. Rather, it’s trying to identify those times you make a decision based on what you assume to be true rather than what is true.
Think about the benchmarks you hold for certain decisions. Try to critique the reasons why you have them. And most importantly, don’t let relatively arbitrary figures, like a $1000 share price, influence your long-term decisions.