The Allure of First Impressions: Understanding the Anchoring Bias

Robert Seaberg, Founder, Intersect Consulting, LLC

“It is a far, far better thing to have a firm anchor in nonsense than to put out on the troubled seas of thought.”

This ironic observation by the longtime Harvard economist and diplomat, John Kenneth Galbraith, helps to explain our propensity to anchor to initial or original figures or amounts. Anchoring is a cognitive bias that often leads to inaccurate and illogical judgments. An extremely powerful mental “shortcut,” it causes us to adjust other relevant information based on the anchor information.

First uncovered by Daniel Kahneman and Amos Tversky in their seminal article, “Judgment Under Uncertainty,” (1974), anchoring seems ubiquitous in our world. Real estate agents, car sellers, negotiators, plaintiffs’ lawyers, financial analysts and investors all rely on this shortcut, just as we rely on others, because too much information and too many decisions require us to resolve matters quickly. Also known as focalism, or the focusing illusion, anchoring leads us to fasten onto a first or original number and then stop making any adjustments once we have reached an implicit range of plausible values — which clearly are closely connected to that original number.2 Adjustment too, it turns out, requires the

expenditure of too much energy in the form of thought, so we take the quick and easy way. Consider the listed price of a home or car: If we can reach an agreed price decently below that original number, we feel we have made a good deal — regardless of whether that first number reflected actual value. Achieving a favorable outcome in negotiation often results from being the first to offer an amount, because subsequent discussion will be pegged to that amount.

The same phenomenon often drives the success of plaintiffs’ attorneys, because court judgments or the amounts defendants accept in a settlement are often determined by the amount of the original demand.

In a later study, Kahneman and David Schkade noted that the focusing illusion affects judgments we make about life satisfaction. That is, easily observed and distinctive differences between physical environments, especially daily weather — for example, living in California as opposed to another state — outweigh factors that actually have a greater impact on happiness, such as job satisfaction, family life and income level. More recent research on anchoring notes that the social context, including attitudes and perspectives, helps determine whether a particular reference point seems credible or extreme.3

Anchoring also appears in many ways in finance and investing. Sean Campbell and Steven Sharpe studied forecast behavior following macroeconomic data releases and found that analysts’ forecasts consistently were based on the prior months’ data, and that they tended to underweight any new information.4 Evaluations of IPOs are pegged to their opening price. And very often, investors’ reactions are tied to stock prices. For example, if any investor purchased a stock at $60, her or his view of the “value” of that stock is tied to $60. If the stock subsequently drops to $45, she or he will often wait for it to get back to $60 before selling. But more deliberation might have led the investor to conclude that the stock originally was overvalued. Likewise, we might consider a stock originally selling for $50 that drops to $30 to be a good value, because we are able to purchase it for an amount substantially below the “original” amount. The same holds true for our thoughts about markets. We might be inclined to view an S&P index that had reached 2200 but which is currently trading at 2150 as an investment opportunity, even though more research might have led us to conclude that at 2200, the index was well-overpriced, and thus that the market may actually have more room to fall. This form of anchoring is known as “self-generated” anchoring, in which we respond quickly with an intuitive approximation of the value of a given number or amount, as opposed to anchors that have been set by others and to which we respond.

The pull of the anchoring bias is so strong that it takes a good deal of effort to mitigate its effects. It turns out that warning people about the effects of anchoring actually helps to increase subsequent adjustments; that is, to extend the range of possible values further from the original.5   The effect of education can be enhanced by doing more research, trying to find evidence of comparability from other sources. James Montier suggests that advisors get investors to anchor to something positive such as income stream, i.e.,

dividends.6   While earnings might be manipulated, dividends cannot. Interestingly, Montier’s advice reveals that there might be something known as “positive anchoring.” In his example, it’s tying decision-making to income streams that cannot be manipulated. The same also is true of connecting judgments to planning, in particular, goals-based planning. If investors were to anchor financial decisions to their goals, such as continuing a lifestyle in retirement comparable to that which they currently enjoy, this would indeed have positive results.

The phenomenon of anchoring reminds us of Daniel Kahneman’s thesis in “Thinking, Fast and Slow,” which contends that human beings in effect have two minds, one that is rational and deliberative, that researches and weighs evidence and then decides, and one that acts more impulsively and quickly. The

former, more rational mind appears lazy and thus leaves most of the thinking to the intuitive brain. And it is this intuitive brain that relies on mental shortcuts, as well as cognitive and emotional biases, to come to those quicker decisions.7 In investing, when Advisors do their job well, they act as a kind of devil’s advocate, getting clients to consider additional evidence, in effect, to “think twice” before acting. Helping clients to think twice may be among the most important thing we do. 

1 John Kenneth Galbraith, “The Affluent Society,” (1958), chapter 11, section IV, p. 130.

2 Nicholas Epley and Thomas Golivich, “Anchoring Unbound,” Journal of Consumer Psychology, 20 (2010).

3 David A. Schkade and Daniel Kahneman, Does Living in California Make People Happy? A Focusing Illusion in Judgment of life Satisfaction,”

Psychological Science September 1998. See also Epley and Gilovich “Anchoring Unbound.”

4 Sean Campbell and Steven Sharpe, “Anchoring Bias in Consensus Forecasts and its Effects on Market Prices,”

www.federalreserve.gov, February 2007.

5 Nicholas Epley and Thomas Gilovich, “The Anchoring-and-Adjustment Heurstic: Why the Adjustments are Insufficient,”

Psychological Science, Vol. 17, Number 4 (2006).

6 James Montier, “Seven Sins of Fund Management: A Behavioral Critique,” DrKW Macro Research, November 2005.

7 Daniel Kahneman, “Thinking, Fast and Slow,” 2011.

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