Cognitive biases are rampant in the world of financial journalism. These biases have far-reaching consequences because they affect they way people make decisions about money. One of the most common (and probably one of the most deleterious) is anchoring.
What Is Anchoring?
In case you don’t have time to read the entire Wikipedia entry, I’ll give you the short version here. Anchoring is a cognitive bias describing the common human tendency to over-weight the first piece of information encountered (the anchor) when making a decision. Have you ever noticed how when somebody tells you Item X is worth $Y you have a hard time bringing yourself to adjust to the notion that, just maybe, X is really worth $Y – $10 even though new, perhaps more relevant information has come to light? Put in layman’s terms, you just can’t unhear something. When a car saleswoman throws out an obscenely high price at the start of negotiations, she’s not actually trying to get you to pay that ridiculous price (not that she would complain if you did), but rather is trying to anchor you to the higher price in the hopes you’ll end up paying a slightly higher price in the end than you otherwise would. And the research suggests you’ll probably fall for it.
Anchoring In Action
The worst thing about cognitive biases is that even the highly educated and those who “should know better” are vulnerable. I was perusing some financial news on the web the other day and came across a rather obvious example of anchoring. It’s a Reuters article entitled Wall Street Week Ahead: A Year Of Returns, All Before Mid-April and I highly recommend you go and read the entire article, or else this one probably won’t make much sense. In it, the author explains how the stock market is already up more in just 3 1/2 months than most analysts had guessed it would be for the entire year. The following quote from one market analyst in particular struck me as odd.
“Here we are now 3 1/2 months into the new year and stocks are up 11, 12 percent – there’s not a whole lot left. Either there’s going to be a pullback at some point, or maybe things really get even better than we thought and our 1,660 target is too low.”
What’s interesting to me is how the conversation is being framed based on what experts predicted the markets would do at the beginning of the year, as if the market already being close to where analysts thought it would be at the end of the year has any bearing whatsoever on what stocks are likely to do in the future. What exactly does this information suggest? That investors should sell because stocks have reached a plateau? Of course not. The market doesn’t know or care what analysts think it will do. But that doesn’t prevent investors from anchoring on the presupposed market level.
Suppose you’re an investor who believes the market will rise 10% in the coming year. Now suppose it’s only mid-April and the market is already up 10%. What would you do? Would you sell some of your holdings in order to “harvest” some gains? Would you take money off the table? Or instead, would you buy more assuming things are going to end up even rosier than you thought? Now suppose you initially thought the market would rise by 20% in the coming year rather than 10%. Assuming the market has risen by 10% by mid-April, what would you do? If your answer isn’t identical to the previous scenario, you’ve fallen victim to the anchoring bias. The rational answer, of course, is to do none of the things mentioned above. Reaching some arbitrary number early in the year tells you nothing about what the market will do going forward, but I digress.
What’s the takeaway from all this? Not much, except perhaps to be wary of listening to experts throw out random numbers. Unfortunately, several studies have found it’s extremely difficult to avoid anchoring once the process has started, so the only way to avoid falling victim is to avoid paying attention to news sources likely to throw out baseless predictions in the first place. That rules out 99% of the financial media, which, to be honest, is probably good for your net worth in the long run anyway.
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