Thinking, Fast and Slow - Anchoring Effect
By The Boy Who Procrastinates - September 01, 2018
Last year, I have read Thinking, Fast and Slow by Daniel Kahneman, a renowned psychologist and winner of the Nobel Memorial Prize in Economics. The book sheds light on the working systems of the human mind and how it can be susceptible to cognitive biases, fallacies and illusions.
The title was first introduced to me during my Managerial Economics lecture when the Professor fervently recommended it to the class and provided only positive review. As it distills a lifetime of research that Kahneman has conducted in collaboration with the late Amos Tversky, some of the ideas demonstrated can be slightly abstract. It usually requires re-reading of certain chapters in order to grasp the essence of the psychological basis for our behaviour and choices. Overall, I must admit that the recommendation certainly did not disappoint at all.
As the book presents numerous compelling insights from the perspective of behavioral economics, I will touch on a few salient concepts and its application on the financial decisions we make on a daily basis.
Anchoring Effect
As Kahneman has defined in his book, the anchoring effect is a form of common cognitive bias that "occurs when people consider a particular value for an unknown quantity before estimating that quantity".
In other words, when we were asked to come up with a number or value for a certain item (e.g. the value of a house) which we do not have an answer to, there is a human tendency to rely heavily on the first available piece of information, known as the "anchor", even if it is not even remotely relevant.
Here's a trivia question: Is the population of Morocco greater or less than 70 million? Make a wild guess if you can.
Now for the next question, how many people live in Morocco? Come up with a figure without googling and keep it in your head.
:
:
:
To demonstrate the anchoring effect, Kahneman has carried out an experiment in which a wheel of fortune, with the wheel marked from 0 to 100, was set in front of a group of students. Unbeknownst to them, the wheel was rigged to stop at either 10 or 65 every time. After spinning the wheel, the students were asked if the percentage of African nations among UN members is larger or smaller than the number indicated on the wheel. The following question requires the students to provide their best guesses of the percentage of African nations in the UN.
The participants who landed on a 10, on average estimated that 25% of African nations was part of the UN while those who have seen 65 on the wheel, guessed 45%. It is apparent that the spin of a wheel of fortune cannot possibly yield any useful information and the students should simply ignore it.
However, when the students were unable to come up with any figures with no other clues, they subconsciously fixated on the information at hand - the number as seen on the wheel, thus skewing their responses completely.
To further illustrate the power of anchoring effect, Kahneman has cited a worrying experiment conducted on German judges with an average of more than 15 years of experience. When passing out prison sentence for crimes of comparable gravity, their judgement were affected by factors as trivial as a dice roll. Personally, I find the experiment to be disturbing as it goes to show how the judicial system can be influenced by random and arbitrary elements.
The participants who landed on a 10, on average estimated that 25% of African nations was part of the UN while those who have seen 65 on the wheel, guessed 45%. It is apparent that the spin of a wheel of fortune cannot possibly yield any useful information and the students should simply ignore it.
However, when the students were unable to come up with any figures with no other clues, they subconsciously fixated on the information at hand - the number as seen on the wheel, thus skewing their responses completely.
To further illustrate the power of anchoring effect, Kahneman has cited a worrying experiment conducted on German judges with an average of more than 15 years of experience. When passing out prison sentence for crimes of comparable gravity, their judgement were affected by factors as trivial as a dice roll. Personally, I find the experiment to be disturbing as it goes to show how the judicial system can be influenced by random and arbitrary elements.
Now, to answer the trivia question earlier, the current population of Morocco is 36 million. Is the figure you have in mind far from the answer?
Financial Applications of the Anchoring Effect
When it comes to finance, we may consider ourselves to be rational creatures who make logical and reasonable decisions based on dollars and cents. However, this may not always be the case as the arbitrary numbers and anchors that we inadvertently encountered can have profound impact on the economic choices that we make.
- Negotiation: Do you recall the last time you haggled with a stall owner in the midst of the buzzing night market in Bangkok? There is a high chance that the seller has quoted a high price when prompted initially. During the course of negotiation, the first suggested price usually set the benchmark for subsequent bargaining and this includes the final price. Such scenarios are also prevalent in salary package discussion with HR, as well as bargaining on Carousell.
- Sales Technique: In the first half of the year, I have attended a financial introductory course. Towards the end of the session, the speaker revealed that the original price of the investment course is approximately $2,000. And if we were to sign up for it on the spot, they are willing to offer a promotional price of $800. By revealing the original price as the anchor, the promotional price, by contrast, creates a clear sense of value for potential customers. Some might have encountered similar experience with Fave/Groupon deals.
- Advertisement: During sales, you may occasionally notice that fashion retailers tend to include the strikeout original price and display the discounted price next to it. The non-discounted price, serving as an anchor, causes potential shoppers to think that they are getting a good deal, thus increasing their propensities to spend.
- Investment: The decision to buy/sell a stock by investors can generally be traced back to the anchoring effect. As it is onerous to measure the true value of a stock accurately, people often anchor on its previous price levels. For instance, investors may anchor on a previous high point for the stock's price and likely to believe that a drop in the price provides an opportunity to buy at a discount. While this may have led to undervaluation of the said stock, it is equivalently essential to understand if the drop in share price reflects any change in the underlying fundamental value of the company (e.g. questionable accounting practice/snowballing of debt).
- Price Anchoring: Some restaurants have included ridiculously priced premium items in their menus to make the next most expensive dish seems cheaper. Customers would deem it reasonably priced compared to the most expensive item and would gladly ordered them. This may have been so despite the fact that the ordered dish could be pricey elsewhere.
Overcoming the Anchoring Effect
Humans have the tendency to rely on heuristics (e.g. rule of thumb/mental shortcut) to form judgement, which allows us to function efficiently in our decision making process. The anchoring effect illuminates how we predict the outcome of events, how we estimate the duration of a process and how we get a measure of how much something is worth. We constantly require an anchor which we can compare against. However, when the anchoring effect rears its ugly head, it may lead to a downward spiral of bad decision-making.
Fortunately, Kahneman has included a few ways to combat the anchoring effect. When the other party makes an outrageous proposal during negotiations, it is recommended to "focus the attention and search memory for arguments against the anchor" and to "make it clear - to yourself as well as to the other side - that you will not continue the negotiation with that number on the table".
Alternatively, the second mover should concentrate on the minimum amount that the opponent would accept or on what it would mean for him not to reach an agreement. Such strategy in general, may be a good defence against anchoring effects as it negates the biased recruitment of thoughts that produces these effects.
When discussing about salary package with prospective employer, it is desirable to initiate the negotiation and set a higher anchor instead of waiting for the HR officer to propose the range. One should also take note that the anchor should not be overly aggressive, as it may cause the other side to question your credibility and risks derailing the negotiation.
The anchoring bias in your investment practices can be overcome with objectivity and constructive approach. Instead of submitting your trade order hastily, do take some time to identify the factors behind the sudden rise/fall in share price. For example, if there has been a change in the fundamental value of the stock, does the adjustment in price level justifiably reflect so? By adopting research-based decisions, discplined investors are usually less susceptible to the anchoring effect.
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Disclaimer: Kindly note that this is not a sponsored post. The author is in no way affiliated with the publisher/author and does not receive any form of remuneration for this post. The Boy who Procrastinates has compiled the information for his own reference, with the hope that it will benefit others as well.
If you do not wish to miss out on any articles, you may consider following the facebook page for timely update.
Disclaimer: Kindly note that this is not a sponsored post. The author is in no way affiliated with the publisher/author and does not receive any form of remuneration for this post. The Boy who Procrastinates has compiled the information for his own reference, with the hope that it will benefit others as well.
1 comments
I enjoy reading books. Thanks for sharing this book details here. Much appreciated. Will definitely check it out.
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