Anchoring Bias – How to make good financial decisions with it

Anchoring bias, or anchoring effect, speaks to the fact that we unwittingly use first impressions to form perceptions that affect our later perception. That is to say, we assign value to one option based on its comparative attractiveness to other options, instead of judging each one based on its own merit.

One common example of anchoring effect you see all the time is the contrast of “original price” and “discounted price.” Let’s say you are shopping for a wearable activity tracker. Since it’s a relatively new product and it’s the first time you’re buying it, you don’t have a very good idea how much it should cost. So you go on Amazon to do some research, and see the following two products:

 

 

 

 

 

 

 

 

 

Without going into the actual product specs, which one do you think is the higher quality product and a better deal? I bet most people would choose the one on the right, because it’s “original” price is $30 more.

In reality, the cost of either product to you would be the same. You don’t know how much it cost to manufacture the product, and you can’t really determine the product’s value to you without reading more about the functions and the reviews. Using a simple trick that appeals to your anchoring bias, I may have convinced you that the true value of a device like this is likely over $100. If a competitor’s product is offered at lower than $100, it must not be as good. And if another competitor’s product is more expensive, but discounted to between $99 and $129, you would probably think it’s a very good deal and consider it, even though the new product is still more expensive.

Note that the anchoring bias may take effect in this case because 1) you don’t know how much these products should cost, like you know about sandwiches and coffees, and 2) you don’t know too much about the product, period. In other words, you use the first information you received on this subject to form the basis of comparison for future information.

If you continue to research this type of product, you will find out that they all differ on functionality and quality and the bias may wane, but I’m positive the $100 price will stick in your mind for a very long time. If you found another similar product with a better review, more functionality, and much more fashionable design, but costs $300, would you consider it? It’s likely it will take you longer to break your initial impression on the value of the product.

Now think how different this exercise would look if you went to FancyWearable.com (non-existent) first and saw all the upmarket products pricing at $300 and above, then searched on Amazon. It will likely make you pull the trigger much faster and maybe choose one priced at $150 – it’s only half the cost of the fancy ones after all so it’s worth it!

Unfortunately we don’t always get to choose what information comes our way first. There are enough decisions to make everyday that we don’t always have the time to notice and avoid our biases plus the mind tricks being played on us. Even if you do try, you probably will soon feel bogged down and paranoid. Therefore, it’s crucial to structure your major financial decisions in a way that anchoring bias may take place for the better, not the worse. Here are some of the steps you can take:

#1: Research – in advance and with an open mind

Anchoring effect is the most detectable when you face uncertainties, because you don’t have prior information to base your current judgment on. How do you get past uncertainty? Get more information.

Since we also have other behavioral and emotional biases that make us only seek out information that confirms our existing beliefs, it’s most helpful to seek information when you don’t have huge financial stakes in it yet and when you are not under time pressure.

For example, if you are buying a home, start researching the basics like neighborhood, mortgage and transaction costs before you even save enough down payment. Don’t go looking for houses yet, but be educated on what buying a house is really like and the finances involved. Another example is learning about financial planning and investing before you have the income or savings for it, so you know where to start when you can.

Once it’s time to take action, your full knowledge will be your anchor so you don’t find yourself having trouble distinguishing what is true and what is false.

#2: Know where you stand

An interesting research shows that political extremists are less susceptible to anchor bias, whether to the left or the right of the spectrum. This is true even for non-political decisions. It is because people who hold extreme political beliefs also think their beliefs are superior to the beliefs of others. In other words, their beliefs act as anchor so they are less likely to be swayed by other information.

If you have strong values, it’s less likely you will anchor financial decisions purely on numbers and comparisons with others. In my “Value Driven Budget” series, I discussed the three criteria I use for purchasing decisions:

• Can I afford it?
• Is it worth the price?
• Is it necessary?

Note that “is it a good deal?” is not on the list. When you make financial decisions based on comparison, by definition you need an anchor for comparison. Depending on what your anchor is, your decision will easily change. Think about a purchase you made recently that only passed the “great discount!” test. If the seller reveals that the cost of the item sold was actually zero, would you still think it’s a very good deal?

When you judge the value of your purchase based on the intrinsic value of the product or service to YOU, you are anchored on something that is unlikely to change, and you will be less likely to be tricked by sales tactics.

#3: Use inertia as your friend

Once you make up your mind on where you stand based on research, you need to turn it into a policy or a habit so inertia to change will keep you anchored at your current state. Inertia is bad for you when you have bad or no habits, but it is your best friend when you have developed good behavior.

For example, after some planning and analysis, you decided that you should automatically contribute 10% of your salary from each paycheck to a 401(k). Bad inertia will keep you from actually logging in to your online account to change the percentage, but good inertia will maintain the 10% savings indefinitely once implemented. Now no matter how much your friends say they contribute, you are anchored on the fact that you’ve done your research and have done the right thing for you. (Of course, creating habits is not always that easy so you may need some help.)

#4: Know what you want

The value of goal-based financial planning lies mainly in the fact it anchors your financial decisions on what you want to achieve, not what others are doing or what you were doing before.

Take investing for example. If your investment goal is to make as much money as possible, it’s likely you will never earn enough, because you will always hear about how other people are getting higher returns than you. When the market goes down, you are surely the first person to call up your broker or financial advisor to find out why your friend seemed able to predict the crash and cash out early.

On the other hand, if you are investing so you can support a retirement lifestyle that YOU want, it’s much easier to determine whether you can reach that goal or not. Even when the market goes down in the short-term, you are less likely to panic because you know that is to be expected and it won’t impact your long-term goal.

In summary, anchoring bias will stay with you forever. Form your first impressions and habits carefully and intentionally, based on your goals and values, and you will go a long way.