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Un-anchor your mind

January 27, 2010 was a momentous day in the history of modern consumer technology. That was the day when the turtleneck-wearing ‘marketing’ genius with the Midas touch, Steve Jobs, first unveiled the iPad. 

As was usual during such unveilings, he was up on a stage in his trademark outfit, addressing a crowd of Apple fans and tech enthusiasts. He started by showing them what the iPad would look like, which predictably drew whoops and cheers. Next, he talked about some of its cool new features: how thin it was, how the screen would rotate automatically depending on the device’s orientation, what a convenient and intimate personal computing experience it would provide, and so on. The crowd was loving the style and the showmanship.

Amidst all the excitement, he finally broached the questions whose answers had the most potential to disappoint the audience: What would the iPad cost? Would Apple loyalists be able to afford it, or would they have to part with an arm and a leg to buy one?

The crowd held its breath. Jobs teased the audience, saying that experts had told the team to price the iPad at just under US$1,000, which effectively put its price at US$999.

People looked down. Hearts sank. That was a LOT of money!

But Jobs smiled and went on. He had just played a massive trick on the entire crowd, you see.

Apple had not just had lofty technical goals, he said, they’d also had lofty pricing goals. They wanted to put the iPad into as many people’s hands as possible.

And so, its pricing would start not at $999, but at $499: a whopping 50% lower!

The crowd? They went wild, heartily applauding this immense revelation.

The iPad went on to become a huge success, selling more than a million units in less than a month.

But what is of interest to us today is the clever way in which Jobs exploited a common psychological bias during the unveiling.

By first bringing up a potential price of $999 before finally revealing it to be $499, Jobs made the latter price seem much better in comparison, even if it was objectively still a pretty steep price, for a product that never really existed earlier. In effect, he used $999 as an “anchor”, which then became the baseline against which the final price would be compared. And it worked like a charm!

This psychological bias is, quite aptly, known as the ‘anchoring effect’ or ‘anchoring bias’, and is pervasive in all human domains, including the world of investing and finance. Let’s learn more about it, so that we can hold on to more of our money for longer.

Understanding Anchoring Bias

Ever wondered why products on e-commerce websites often show an “original” price that seems to be ‘struck off’ and replaced with a discounted price, ‘just for you’? This is a strategy that tries to take advantage of anchoring bias. When buyers see the original price, it becomes a subliminal anchor in their minds, and then the offer price seems much more reasonable in comparison.

Steal deals, limited-time offers, and offers of the day even in supermarket aisles are all based on this idea. When you see a product at a price slightly lower than usual, you jump at the opportunity and are more likely to buy. Which is why this special deal is always clearly shown to you being compared with the older, ‘normal’ (which very often is not normal) price. This explains why most products you search for, also seem to be on a limited-time deal.

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Behavioral finance describes anchoring as the tendency to compare prices with an irrelevant benchmark. This arbitrary benchmark value affects subsequent perceptions of pricing and thus drives decisions a certain way. It is a psychological bias that may lead to poor financial decisions.

On the other hand, it can also be a powerful tool during negotiations. Setting a high or low anchor, depending on which side the table you sit, at the beginning of a negotiation can help you obtain a more favorable outcome. 

The impact of anchoring bias on financial decisions

Anchoring bias affects perception by “freezing” in the mind, the first pieces of information that we get about prices of products. All subsequently received information is then processed through the lens of that anchor. This can have a tremendous impact on the financial space because prices are the central element of all transactions. While brands around the world use anchoring bias in their favor and earn profits off it, it can cause investors to lose significant sums of money.

In investing, anchoring bias can greatly influence decisions.

My neighbor Joji absolutely loves equity MF launches (New Fund Offers or NFOs, as the industry calls them) simply because the NAV at launch is Rs 10. What makes him excited? When he sees similar older funds from other AMCs at NAVs of 80/ 120/ 200 or more. In comparison yes, 10 is lesser than 120 and 200 but anchoring his thought process to a Rs 10 price is ridiculous. I’ve explained to Joji countless times about this mistake he makes, but he does make it a point to call me anytime he sees an NFO ad, asking me “Isme daalun kya?”

His son Sasi then has a whole other theory. He loves to find funds that have returned 75%+ in the last 3 years and uses this as a cut off for what he calls a ‘high-growth strategy’. He doesn’t bother to see if the fund had fallen by 50% the year before the 3 year period- which means even a 100% growth over the next 3 years barely helps the fund recover its prior losses! And the worst thing- he then expects these funds to do as well over the next 3 years too. Needless to say, his overall portfolio returns don’t even beat the rate of inflation.

Dhruv, my ex-college-mate who works in one of the Top 3 consulting firms recently called me, telling me he was stuck. He had purchased 1000 units of a stock in 2016 at Rs 500 and expected the stock price to grow to Rs 1200 in a year, based on a tip he had received. The stock fell to Rs 70 within 6 months of his buying it, and since then hasn’t crossed the Rs 100 barrier. He didn’t exit, doesn’t know why he remained invested and didn’t even tell anyone about this. Why? The expected price of Rs 1200 was anchored in his mind. Then he reworked this goal to say a price of Rs 500 is good enough to at least get his capital back. This prevented him from focusing on the fundamentals and recognizing that this stock might never end up rising even above the purchase price- apart from becoming an absurd example in this blog :)

Haven’t we all also heard of people who only look at 52-week highs and compare current stock prices to then make trading decisions, without analyzing whether the stock was or is fairly priced, cheap or expensive? Again- they’re anchored to an often-irrelevant number.

Some common anchors in investing include purchase prices and high-water marks. While these values are used for purposes like achieving a minimum in net profits or realizing target returns, they may have little to do with market pricing, and can prevent investors from making sound, profitable exit decisions!

Why is anchoring bias so tricky to deal with?

According to research, anchoring bias works differently for different people. Even if people are aware of this bias and want to compensate for it, they cannot nullify its effect completely. Here are some factors that make this bias especially tricky to deal with in the world of investing:

- Anchors are often chance-dependent and may be completely unrelated to the intrinsic value of an investment.

- This bias can cause various kinds of unhealthy fixations among investors, such as a fixation on the past performance of an investment. For instance, real estate ‘investments’ were very common 15-20 years ago, with one often hearing stories of those whose property doubled in value in just a few years. With the digital age coming, a lot more information started coming out about those whose money got stuck in incomplete projects, or their property value fell, or it simply didn’t rise enough to even beat inflation over an 8–10-year period. Although other financial instruments have stood the test of time and often offer more consistent returns, a considerable number of (older) investors might still invest in real estate as a primary investment instrument.

- Anchoring bias can blunt investors’ response to news and developments, leading to potentially profitable decisions being delayed. For instance, even if a company announces major profits, investors might still put off investing in it for a long time just because its past performance is still anchored in their minds.

- Anchoring bias can also act as a “gateway bias” and make investors more vulnerable to other biases, such as confirmation bias and recency bias.

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Combating Anchoring Bias

In the world of investing, there is no replacement for research and analysis. However, we often tend to look for quicker and easier ways to make decisions. Our biases often play into the hands of this need, and we end up trusting our perceptions more than we should.

The simplest and most effective way to overcome anchoring bias is to rely on analysis and data more than perceptions.

Imagine going to a job interview and basing your expected salary only on your last salary. From your point of view, by doing so, you will quote a sum higher than your current income, and hopefully get a salary that’s an improvement on your previous one. However, for all you know, the organization might have had a higher budget for the role, or you might have been getting underpaid earlier. Hence, researching the salaries that the organization typically offers, interacting with past and existing employees, and getting an idea of the kinds of hikes they offer is a better way to decide what you should quote. The same goes for investing.

Doing your due diligence when deciding to buy or sell stocks or MFs can help you minimize the impact of anchoring bias. If an equity MF’s NAV has risen by 5% in the last 6 months, it is too simplistic to assume that it’ll grow by 5% in the next 6 months too, to then estimate potential returns after 3-5 months. However, this is exactly how most people might be thinking at a subconscious level!

A better way of assessing such a situation is really to use tried-and-tested analytical models before making investing choices. Can you study prior stock price movements, the cycles they’ve gone through in the past, the business potential of each company you’re looking at, the management teams of such businesses and what not, instead of relying on a crude multiple-based approach? What about looking at the news and the latest developments? Will this not help you arrive at better models to make price predictions?

Critical thinking is the best way to prevent poor decisions. Yes, it is not easy, it takes time and effort. But it is the only way to invest better. Unless of course, you work with a reputed MFD, financial advisor, or a broker to study the various stocks or mutual funds before investing. 

Track your behavior and identify common anchors that might cloud your judgment and take conscious steps to reduce their hold on you.

So don’t get played and don’t be like Joji, Sasi or Dhruv. In fact, if you must be something or someone, #BeACockroach!

Otherwise you might end up like my other hero, Uncle Roger 😊

 

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A good starting point to make rational, unbiased investment decisions is to identify your own investing style and your risk profile. Introducing Sarthi, our awesome Personalized Online Risk Assessment Tool, which can help you easily identify your risk-taking style (it goes one step further and gives you a personalized asset-allocation recommendation based on your responses). Thousands have already tried it. Give it a shot below:

 

About the author

The Rational Ghost. This is one rational storyteller that provides interesting insights & stories about investing and tries to be completely unemotional about it. Lives in the shadows, doesn’t want anyone to know its real name.

Disclaimer

This note is for information purposes only. In this material DSP Investment Managers Pvt Ltd (the AMC) has used information that is publicly available and is believed to be from reliable sources. While utmost care has been exercised, the author or the AMC does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers, before acting on any information herein should make their own investigation & seek appropriate professional advice. Any sector(s)/ stock(s)/ issuer(s) mentioned do not constitute any recommendation and the AMC may or may not have any future position in these. All opinions/ figures/ charts/ graphs are as on date of publishing (or as at mentioned date) and are subject to change without notice. Any logos used may be trademarks™ or registered® trademarks of their respective holders, our usage does not imply any affiliation with or endorsement by them.

Past performance may or may not be sustained in the future and should not be used as a basis for comparison with other investments.

Mutual fund investments are subject to market risks, read all scheme related documents carefully.

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