Anchoring is a common psychological effect whereby people tend to rely too heavily on readily available information (the “anchor”) when making decisions involving uncertainty.
To illustrate the point, let me ask you two questions:
- Is the population of Argentina greater or less than 80 million?
- How many people do you think live in Argentina?
Write down your answers to these two questions, and then continue reading.
Have you written down your answers?
If you are like most people, then you probably have no idea how many people live in Argentina. In order to take a guess, it helps to have some kind of reference point and my first question gave you a clue: Is the population of Argentina greater or less than 80 million?
The population of Argentina is actually around 41 million, about half of the anchor I provided.
How far off were you?
If you are like most people then your guess probably overshot the mark by quite a bit. You couldn’t help but be influenced by the information that I provided, even though the information was arbitrary and extremely inaccurate.
Anchoring is a quirk of human psychology that can be used to entertain first year psychology students, but more importantly it is a common and pervasive cognitive bias that affects the way in which people make decisions and is relevant in many business contexts.
Here are just three (3) examples:
1. Price Negotiations
A sophisticated buyer in a price negotiation will always want the seller to name the first price. By making the seller name her price this sets an anchor, a maximum price from which the buyer can negotiate downwards.
If the seller names an unrealistically high price then the buyer will want to emotionally reject the price, perhaps by exclaiming shock, disgust or pretending to walk away.
The buyer may still be interested in continuing the negotiation but by emotionally rejecting the initial offer the buyer hopes to break the anchor so that negotiations can begin afresh.
I once bought a Helmut Lang sweatshirt retailing for $400, which happened to be on sale for $80.
Up until sitting down to write this article I had always believed that I had scored an incredible bargain, but the reality appears to be quite different.
Retailers use the “recommended retail price” as an anchor. At sporadic intervals they can then offer a far more reasonable “sale price” which draws shoppers to the store in the belief that they are obtaining a bargain.
The sale price may in fact be a bargain, but only in the same sense that my Helmut Lang purchase was a bargain; a reduction in price from an artificially high starting point.
3. Stock Trading
Algorithmic traders can use their knowledge of anchoring to gain a statistical edge in the stock market.
Many traders will use a recent high or low price as an anchor to determine whether prices are “too high” or “too low” and an algorithmic trader can use this fact to develop trading systems that allow her to trade with positive expectation over the longer term. (For a good book on this subject, get yourself a copy of Way of the Turtle by Curtis M. Faith.)