Anchoring and Adjustment

Definition

Anchoring and adjustment is a psychological heuristic that influences the way people intuitively assess probabilities. It involves starting from an initial value (the “anchor”) and adjusting it to reach an estimate or decision. In financial terms, it refers to the tendency of investors to hold onto a reference point for making decisions, such as a stock’s high and low points, and then adjust that reference point based on new information.

Phonetic

Anchoring: /ˈæŋkərɪŋ/Adjustment: /əˈdʒʌstmənt/

Key Takeaways

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1. Anchoring: Anchoring refers to a cognitive bias where an individual depends too heavily on an initial piece of information (the “anchor”) to make subsequent judgments during decision making.
2. Adjustment: Humans often make adjustments to the ‘anchor’ , moving towards their own thoughts or values, but the adjustments are typically insufficient. As a result, the final answer still remains closer to the initial anchor, even if it is irrelevant or random.
3. Influence on Decisions: Anchoring and adjustment can significantly influence our decisions and judgments in many aspects of life, from financial decisions to personal evaluations. Understanding this bias can help in making better, more informed choices.

“`Output will look like:1. **Anchoring:** Anchoring refers to a cognitive bias where an individual depends too heavily on an initial piece of information (the “anchor”) to make subsequent judgments during decision making. 2. **Adjustment:** Humans often make adjustments to the ‘anchor’ , moving towards their own thoughts or values, but the adjustments are typically insufficient. As a result, the final answer still remains closer to the initial anchor, even if it is irrelevant or random. 3. **Influence on Decisions:** Anchoring and adjustment can significantly influence our decisions and judgments in many aspects of life, from financial decisions to personal evaluations. Understanding this bias can help in making better, more informed choices.

Importance

The business/finance term: Anchoring and Adjustment is important because it plays a key role in decision making, and impacts financial dealings significantly. This cognitive bias, wherein individuals latch onto an initial piece of information (the “anchor”) and then make adjustments based on that reference point, often results in considerable inaccuracies or inefficiencies. For instance, when determining the value of investments, buyers or investors might focus excessively on the initial prices or historical trends while disregarding recent changes in market conditions. This can lead to misestimations of value and poor financial decisions. With an understanding of how anchoring and adjustment work, individuals can actively check these biases, making more balanced, logical, and potentially beneficial financial judgments in the future.

Explanation

Anchoring and Adjustment is a psychological heuristic that heavily influences all types of decision-making, including those in finances and business. This concept refers primarily to the common human tendency to rely too heavily upon, or “anchor” , on an initial piece of information (the “anchor”) when making decisions. The initial information that is considered, or the anchor, serves as a reference point and adjustments are made based on this to reach a final decision or value. Within the realm of finance and business, this concept is used to understand, predict, and possibly manipulate consumer behavior and decision-making. For example, a retailer might use anchoring to set high initial prices (the “anchor”) and then offer discounts off this price, altering the perception of value and making the lower prices seem more attractive. Investors may also anchor their perceptions of a company’s value to past performance, regardless of changes in its fundamentals. Understanding these tendencies can help business and finance professionals to make more effective decisions and strategies.

Examples

1. Salary Negotiation: When a job candidate is discussing salary, the initial offer provided often serves as an anchor. If an employer proposes a salary of $50,000 per year, for instance, the candidate is likely to negotiate around that number, even if they were expecting a higher salary. The negotiation process is then an adjustment around this anchor.2. Real Estate Pricing: Suppose a house is listed for $300,000. That price serves as an anchor and impacts all future negotiations. If a potential buyer thinks the house is worth less, they might offer $280,000. In this situation, the buyer has made an adjustment based on the anchor price. 3. Stock Market Analysis: If a stock analyst sets a target price for a stock at $100 per share, investors might use that price as an anchor. If the actual stock price is currently $85, they might believe it’s undervalued and buy shares expecting the price to rise to the target price. Similarly, if the price is $120, they might believe it’s overvalued and sell shares, expecting it will decrease to the analyst’s target price. The actual trading prices of the stock reflects the investors’ adjustments around the anchor price.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Behavioral finance
• Cognitive bias
• Decision making
• Heuristic theory
• Market forecasting

Sources for More Information

• Investopedia
• Corporate Finance Institute
• Behavioral Economics
• Simply Psychology