What is anchoring bias?

In trading, anchoring bias is a cognitive bias that occurs when a trader relies too heavily on a single piece of information or past experience when making decisions. A simpler anchoring bias definition is that it is the tendency to use first impressions to form further perceptions. 

Anchoring, also known as anchoring effect or focalism, is part of behavioural finance studies, which examines how emotions and other external factors impact economic choices.

Below, we have anchoring bias explained in detail. 

Highlights 

History of anchoring bias

In the 1970s, several studies by psychologists and economists Daniel Kahneman and Amos Tversky explained the effect and definition of anchoring. The purpose of the studies was to explore how people formed judgements when they were unsure of the facts. They found that when uncertain about the correct answer, people would take a guess using the most recent number they’ve heard as a starting point.

In one of their experiments, participants were told to spin a wheel to select a number from 0 to 100. They were then asked to adjust that number, lower or higher, to indicate how many African countries were included in the UN. Those who spun a lower number gave lower estimates, while those who spun a higher number gave higher estimates. In either scenario, the participants were using the initial number on the wheel as their focal point to base their final decision on.

Tversky and Kahneman explained in their 1974 paper: “People make estimates by starting from an initial value that is adjusted to yield the final answer.”

Why does anchoring bias happen?

Anchoring bias may be found at any point of the trading decision-making process and could happen for a few reasons. These include, among others: 

• Limited time and attention for decision-making

• Over-reliance on heuristics or mental shortcuts

• Cognitive biases and irrational thinking

• Emotional attachment to prior prices or positions

• Overconfidence in one’s own analysis or judgement

Limited time and attention for decision-making: Traders often face time constraints and must make quick decisions under pressure. This can lead to shortcuts in processing information, such as relying too heavily on initial prices or other anchoring information, and not considering all available data. Traders may also suffer from decision fatigue, making them more likely to rely on familiar heuristics or cognitive biases.

Over-reliance on heuristics or mental shortcuts: In the absence of complete information, traders may rely on mental shortcuts or heuristics to make decisions. For example, traders may anchor on the initial price of a stock and fail to adjust their valuation based on new information, such as changes in market conditions or company fundamentals.

Cognitive biases and irrational thinking: Traders could be susceptible to cognitive biases, such as confirmation bias, where they may seek out information that confirms their existing beliefs and ignore information that contradicts them. This can lead to anchoring on initial prices or other information, even if it is not relevant to the current market conditions.

Emotional attachment to prior prices or positions: Traders could become emotionally attached to their prior positions or prices, leading to anchoring bias. This could be particularly problematic if a trader is holding a losing position and refuses to sell even when new information suggests that they should. Emotions such as fear, greed, and regret can also play a role in anchoring bias.

Overconfidence in one’s own analysis or judgement: Traders may overestimate their own ability to analyse market data and make predictions, leading to anchoring on their initial analysis or judgement. Overconfidence can also lead traders to ignore contrary evidence or downplay the importance of new information that contradicts their initial analysis.

Effects of anchoring bias

Commonly when experiencing this bias, traders are aware that their anchor is deficient. And while they try to make adjustments according to the latest information and analysis, these may remain influenced by the bias of the original anchors.

Some of the possible effects of anchoring bias include: 

• Making suboptimal trading decisions based on initial information or prices

• Creating false expectations about future prices or trends

• Overvaluing or undervaluing assets based on irrelevant information

• Increasing risk exposure

• Failing to adjust valuations based on new information

• Ignoring important market signals or trends

• Holding onto losing positions for too long

• Failing to buy or sell at optimal prices

• Reducing overall portfolio performance

Examples of anchoring bias

To better understand the concept, let’s take a look at the example that demonstrates how anchoring bias can affect decision-making in everyday situations.

Imagine a person is in the market to buy a new car. When searching online, they see a car priced at $10,000. However, they’re uncertain about the car’s value and decide to do some research before making a decision. 

During their research, they come across a similar car at a local dealership, priced at $15,000. This causes the person to anchor to the $10,000 price they saw at the first dealership, and they begin to view the $15,000 car as overpriced.

They quickly accept the online offer as they now perceive it to be a good deal, missing out on better options or deals available at other dealerships. Anchored to the original price they saw, they forget to consider other factors such as the car’s safety rating, resale value, or fuel economy. 

In trading, anchoring bias can take on several forms. Below are hypothetical situations that demonstrate how the bias can manifest itself in one’s decision-making:

• A trader buys contracts for difference (CFDs) on the FTSE100 (UK100) Index. A trading session started off with a bullish run. The trader feels certain that the day would continue in an uptrend, as they were essentially anchored to the information about the “bullish run” they received earlier that day. When the market shows clear signs of exhaustion, they still claim it is bullish. 

• A trader buys CFDs on Apple (AAPL) shares at a high price. The share price begins to drop. The trader becomes anchored to the original purchase price and continues to hold onto the stock, hoping that the price will rebound, even as it continues to fall.

• A trader buys CFDs on Tesla (TSLA) shares based on the stock’s price hike in the past year. The trader becomes anchored to the past performance and assumes that the stock will continue to rise at the same rate, without considering other important factors such as market trends, competition, or the company’s financial health. 

How to avoid anchoring bias

Below are some points you may want to consider to combat your anchoring bias. Note that you should conduct your own research beyond this article before making a trade. 

Acknowledge it: Ask yourself questions that may reveal anchoring behaviour and recognise whether your decisions are emotionally driven. When deciding whether to buy, sell or hold an asset, think about whether you are giving enough consideration to all of the available information and possible options.

Challenge assumptions: Actively challenge your assumptions and expectations by considering alternative scenarios and potential outcomes. This could help avoid becoming fixated on a particular reference point or future expectations.

Seek diverse information: Seek out diverse sources of information, rather than relying solely on a particular data point or news headline. This could help provide a more complete and accurate picture of the trade’s potential.

Implement trading rules: Set strict trading rules that could help avoid making impulsive or irrational decisions. For example, you could establish a maximum percentage of your portfolio to allocate to a single asset.

Diversify your portfolio: Diversify your portfolio across multiple assets or instruments as it could potentially help avoid becoming too attached to a particular position.

Keep your emotions in check: Maintain self-discipline. Trading can be a highly emotional activity, especially when sudden market news results in high volatility.

Use a systematic approach: Implement a systematic approach to trading as a way to reduce the impact of emotional biases in general. The approach could involve developing a clear set of trading criteria and sticking to them, rather than relying on intuition or subjective judgments.

Keep a trading diary: A trading diary or journal could help you keep track of your decision-making process, as well as wins and losses to identify performance mistakes and analyse whether anchoring bias has been at play.

Essentially, one of the keys to overcoming anchoring bias could be to try to be objective and flexible, and to be able to evaluate prices and make decisions impartially, regardless of what your current position is. 

Conclusion

Anchoring bias in trading is the tendency to rely too heavily on the first piece of information one receives when making a decision, leading to an overestimation of the importance of that information. This could often result in a trader sticking with an initial decision despite new information that may suggest otherwise. 

Anchoring bias can be found at any point in the financial decision-making process and may be caused by a combination of other cognitive biases, emotions, and the complexity of the decision-making process in trading.

To combat this cognitive effect, traders could consider diversifying their portfolios, seeking diverse information, maintaining a trading journal, and keeping their emotions under control, among other tactics.