Many cognitive biases can influence our decision-making process, and anchoring bias is one of them.
In our ongoing personal finance bias series today, we will explore what anchoring bias is, how it can affect our personal finances, and most importantly, how to overcome it.
By understanding and addressing this bias, we can make more informed and rational investment decisions.
Estimated read time: 4 minutes and 40 seconds
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Buckle up. Here we go!
What is anchoring bias?
Anchoring bias refers to the tendency to rely heavily on the first piece of information we are given when making financial decisions. It occurs when we use the initial piece of information, regardless of the accuracy of that information, as a reference point for making subsequent judgments or choices.
In personal finance, this bias occurs when we anchor our financial decisions to certain fixed points, such as past prices or arbitrary benchmarks, without considering other relevant factors.
For example, let’s say you want to invest in a stock, and you see it was trading at a significantly higher price a few months ago. You might anchor your decision-making process to that higher price, assuming the stock is cheaper now.
This anchoring bias can cloud your judgment and prevent you from objectively assessing the current value and potential risks associated with the investment.
How does anchoring bias affect your personal finance?
Anchoring bias can have a significant impact on your personal finance. Here are a few ways this bias can affect your decision-making:
1. Asset valuation
When evaluating investments, anchoring bias may cause you to focus on past prices or market highs, leading you to overvalue or undervalue an asset. This can prevent you from objectively assessing its current worth and potential risks.
2. Spending habits
Anchoring bias can influence your spending habits by setting an arbitrary reference point for what you consider normal or reasonable expenses. This can lead to overspending or underspending without considering your financial situation or other relevant factors.
3. Negotiations and bargaining
Anchoring bias can affect your ability to negotiate effectively. If you anchor your expectations to an initial offer or price, you may miss out on better deals or cannot recognise fair offers.
For example, imagine you are buying a new laptop online. You come across a popular e-commerce website that listed the laptop you want for ₹75,000 at a sale price. However, you notice the website shows the original price of the laptop as ₹95,000 showing a ₹20,000 discount.
Due to anchoring bias, the original price of ₹95,000 becomes the anchor, influencing your perception of the laptop’s value and potential savings.
You might be more inclined to consider the ₹75,000 price tag a great deal because it is significantly lower than the inflated anchor price. As a result, you may feel more compelled to make the purchase, believing you are getting a substantial discount.
In this scenario, anchoring bias affected your negotiation and bargaining power as a consumer. The e-commerce website strategically presents the original price as a reference point to create a perception of a larger discount and encourage immediate purchase decisions.
Strategies to overcome anchoring bias
Avoiding anchoring bias entirely probably isn’t possible. Like all cognitive biases, anchoring bias happens subconsciously, and when one isn’t aware something is happening, it’s difficult to interrupt it.
But the below strategies can help you to overcome anchoring bias to some extent and help you make more rational financial decisions:
1. Awareness and mindfulness
The first step in overcoming anchoring bias is to be aware of its existence. Recognise that your initial reference point may not always be the most accurate or relevant. Be mindful of your thoughts and emotions when making financial decisions to avoid being swayed solely by the anchor.
2. Seek diverse perspectives
Gather a variety of opinions and information from different sources. By considering multiple viewpoints, you can challenge your initial reference point and develop a more well-rounded understanding of the situation. Seek advice from trusted experts or consult with knowledgeable friends and family members.
3. Conduct independent research
Take the initiative to research and analyse the relevant factors beyond the initial anchor to form a more objective assessment. This will help you decide based on a comprehensive understanding rather than relying solely on a single reference point.
4. Set personalised goals
Define your financial goals and establish a personalised plan. By setting clear objectives based on your unique circumstances, you can avoid being influenced by random reference points. Align your decisions with your aspirations rather than external benchmarks.
5. Consider alternatives and probabilities
Instead of fixating on a single outcome, consider various scenarios and their probabilities. This approach helps you think more flexibly and consider a range of possibilities, allowing you to make more informed decisions based on a broader perspective.
6. Regularly review and update
Financial circumstances and market conditions change over time. Regularly review your financial decisions, investments, and goals. Avoid anchoring to past decisions and be open to adjusting your strategies based on new information.
Now let’s continue with our above example of buying a new laptop. In that scenario, to overcome anchoring bias, it’s crucial to recognise that the listed original price is not the sole determinant of the laptop’s current value.
It’s necessary to take a step back and consider additional factors. Research and compare prices across multiple websites to get a better understanding of the laptop’s actual market value. Look for customer reviews, warranty information, and other relevant details to make a more informed decision based on the laptop’s true worth.
Additionally, be mindful of other online sales tactics, such as limited-time offers or flash sales, which can further exploit anchoring bias. Take the time to evaluate the product’s features, specifications, and suitability for your needs rather than solely focusing on the anchor price provided by the website.
By conducting independent research, considering multiple sources, and evaluating the laptop’s value based on objective factors, you can make a more informed decision.
Don’t let the anchor price solely dictate your perception of value and potential savings. Instead, approach e-commerce purchases with a critical mindset, ensuring that you are making a well-informed decision that aligns with your needs and budget.
Our thoughts on anchoring bias
Anchoring bias can significantly impact your personal finance by distorting your judgment and preventing you from making rational decisions. By understanding this bias and adopting strategies to overcome it, you can enhance your financial decision-making abilities.
Stay mindful, seek diverse perspectives, conduct independent research, set personalised goals, consider alternatives, and regularly review your financial choices.
Remember, overcoming anchoring bias is a continuous process that requires conscious effort and a willingness to challenge your initial assumptions. With practice, you will be better equipped to make sound financial decisions that align with your goals and improve your overall financial well-being.
Also, check out other biases covered by us – loss aversion, overconfidence and mental accounting bias.
Remember to share these insights with your buddies.
Still Curious?
If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.
The Decision Lab – Why we tend to rely heavily upon the first piece of information we receive
Zerodha Varsity – How anchoring bias affects your investing decisions
Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.