Anchoring biases and financial decisions

financial decison process of a businessman affected by the anchoring effect with sticks

Throughout this article we will discuss about how anchoring biases affects financial decisions. In addition we will give some tips that will allow you to avoid its limitations thanks to behavioral economics’ studies.

What is anchoring bias?

The anchoring bias is a cognitive bias that refers to the tendency of individuals to rely too heavily on the first piece of information they receive when making decisions.

This initial piece of information is denominated “the anchor”. It often serves as a reference point or starting point for subsequent judgments or decisions. People adjust their judgments or decisions away from the anchor. However, they often don’t adjust far enough, leading to systematic errors.

Anchoring bias can be observed in various contexts, such as negotiations, pricing, or financial decisions. Here’s an example:

Imagine you’re at a car dealership looking to buy a new car. The salesperson starts by showing you a car with a high price tag, let’s say $60,000. This initial high price becomes an anchor in your mind. Even if the salesperson later presents a lower price, say $45,000, you might perceive it as a good deal because it’s lower than the initial anchor. However, without the anchor, you might not have considered a $45,000 car to be a good deal at all.

Anchoring bias can lead to irrational decision-making because people are often influenced by irrelevant information that should not influence their judgment.

Being aware of this bias is important in order to make more rational and objective decisions. It’s recommended to consciously question the relevance of the initial information. Thanks to that, you will consider a broader range of options when making decisions.

How can the anchoring bias affect our financial decisions ?

Anchoring bias can significantly impact our financial decisions by leading you to make suboptimal choices that are influenced by irrelevant or arbitrary information. Here’s how anchoring bias can affect various financial decisions:

  1. Purchasing Decisions: When buying products or services, the initial price you encounter can serve as an anchor. That influences how much you’re willing to pay. For instance, if you see an item originally priced very high but then offered at a “discounted” price, you might perceive the discounted price as a good deal, even if it’s still higher than the item’s true value.
  2. Investment Decisions: Investors can be prone to anchoring bias when valuing stocks or other assets. If you anchor on a recent high price for a stock, you might hesitate to sell it even if its current value has dropped significantly. You might also anchor on the price you paid for an asset. Which leads you to hold onto it even if it’s no longer a good investment.
  3. Salary Negotiations: Anchoring bias can affect negotiations related to your salary or compensation. If your current or previous salary serves as an anchor, you might be hesitant to ask for a significantly higher salary, even if your skills and the market value suggest you deserve more.
  4. Budgeting: Anchoring bias can affect how you allocate your budget. If you start with a certain spending level as an anchor, you might be less willing to reduce spending in certain categories even if it’s financially prudent to do so.
  5. Real Estate Transactions: When buying or selling a property, the initial listing price can serve as an anchor that influences your perception of the property’s value. This can lead to overpaying for a property. If you anchor on the listed price without considering comparable properties or market trends, your decisions are biased.
  6. Loan Decisions: Anchoring can also affect loan decisions. If you’re presented with a loan offer that has a high initial interest rate, you might be more likely to accept it without shopping around for better rates, even if you could secure a more favorable loan elsewhere.

How to mitigate the impact of the anchoring bias on our financial decisions ?

To mitigate the impact of anchoring biases on your financial decisions:

  • Research: Gather as much information as possible before making a decision. Consider multiple sources of information and various perspectives to avoid anchoring on a single piece of data.
  • Set Clear Criteria: Establish clear criteria for your decisions in advance. This can help you evaluate options objectively rather than being swayed by the initial information.
  • Seek Independent Advice: Consult with financial advisors or experts who can provide an unbiased perspective and help you make informed decisions.
  • Take Your Time: Give yourself time to deliberate and consider alternatives before making a decision. Avoid making impulsive choices based solely on the first piece of information you receive.
  • By being aware of the anchoring bias and actively working to counter its effects, you can make more rational and effective financial decisions that align with your goals and financial well-being.