On Our Minds: Anchoring Bias Can Be a Drag for Investors

I once scored a pair of jeans on clearance for $11. I was elated – what a deal! In the years that followed, I met every compliment (of which there were several – they were pretty fabulous pants) with some variation of "Thanks! They were only 11 bucks!" Conversely, I've seen reports of diamond-encrusted denim with a price tag north of $1.7 million. Clearly, when it comes to jeans, prices vary vastly. But how much should a pair cost? Is it $50, $150 – or even $500? Taking into account a well-recorded psychological phenomenon called anchoring, it turns out there is no one-size-fits-all answer.

Anchoring, or the anchoring effect, is a cognitive bias wherein the brain overly focuses on a specific piece of information — often the first piece it gets — when trying to estimate a sum. Having established a starting place, our brains then consider the circumstances more critically and adjust the estimate, but the final sum tends to sit quite close to the initial one, meaning the result is inherently skewed. Notably, even when a number is completely arbitrary, it can influence our thinking: In the landmark 1974 study that helped identify the anchoring effect, participants were first given numbers chosen with a wheel of fortune and then asked to guess the proportion of participating African countries in the United Nations.

So you and I could look at the same pair of jeans and have entirely different expectations of what the price tag ought to say. My brain may lowball the price and guess $30. If the price is actually $100, the resulting sticker shock might cause me to skip out on good value, which is particularly regrettable if my closet is deficient in denim. On the other hand, if your brain overshoots and guesses $250, you'll think $100 is a steal — even if the quality is poor or the jeans aren't your style.

In much the same fashion, anchoring can sway your investing decisions. By missing the mark on what constitutes a fair price, your mind can trick you into overpaying for a stock or buying a security that doesn't suit your goals; likewise, the effect can warp selling decisions.

More problematic still, anchoring can piggyback onto another cognitive distortion called confirmation bias, which causes us to seek information that confirms our previously held beliefs. Let's say at some point in the past you decided $50 was a fair price to pay for something and you bought it. The next time you come across this valuation, your mind will have a stake in upholding that it is a fair price to pay, something you may very well achieve by buying. If the price is objectively too high, a vicious cycle may form: A valuation error made once can repeat itself over and over.

Does this whirlwind of mis-valuing have you a tad dazed? Don't despair. As with anything, knowledge is power. Being aware of anchoring and how confirmation bias can amplify it can help us mitigate its effects. The next time you evaluate the fairness of a price, be it for slacks or a stock, choose your starting place critically and consciously, and don't let past decisions influence you.