Anchoring effect in trading

Anchoring effect in trading

What is anchoring effect?

The anchoring effect is a cognitive bias that influences our decision-making process. It occurs when we rely too heavily on an initial piece of information, known as the anchor when making subsequent judgments or estimates.

When people encounter an anchor, it serves as a reference point or starting point for their thought process. Subsequently, they adjust their judgments or decisions based on this anchor.

Again it’s coming back to loss aversion.

For example, let’s consider a pricing scenario.

Suppose a customer is looking to buy a new laptop and encounters two options: one priced at $1,000 and another at $2,000.

The customer may perceive the $1,000 laptop as a good deal compared to the $2,000 option, assuming that the $1,000 price is a reasonable anchor.

However, if the customer had seen a $3,000 laptop as the initial anchor, the $2,000 laptop might seem like a better deal.

The anchoring effect is pervasive and can influence various aspects of decision-making.

It occurs because our brains tend to rely on shortcuts and heuristics to process information quickly. When confronted with a new piece of information, our minds tend to latch onto it and use it as a mental reference point for subsequent evaluations.

How anchoring effect affects trading?

The anchoring effect can have a significant impact on trading decisions.

This anchor may be influenced by various factors, such as previous trades, recent market movements, or analyst recommendations.

For example:

Suppose you come across news about stock XYZ, indicating that the company is developing a new drug with potential cancer-curing properties. After conducting research and finding positive reports and successful clinical trials, you decide to purchase shares of that stock.

Despite your initial expectation that the stock price would rise, it instead begins to fluctuate.

Additionally, you come across news that the CEO of the company sold some shares. However, you maintain your belief that the stock is still in a good position due to the company’s development of a promising drug that you anticipate will be successful.

Although reports emerge indicating that the drug did not work for some patients, you still hold onto your belief that the stock will increase in value.

Furthermore, you become aware of employee layoffs, suggesting potential difficulties with the drug’s development and possible delays in its release.

Despite these negative indicators, which raise doubts about the drug’s effectiveness and market viability, you continue to anchor your perspective to the initial positive information you received.

This behavior is common among all individuals as it is inherent to human nature.

Once you establish a position based on a particular reason, subsequent developments and events may occur that alter the situation. However, despite these changes, you continue to anchor yourself to the initial reason, giving it more weight than it deserves. Consequently, you tend to underestimate or disregard new information that emerges along the way.

Your bias persists because you remain anchored to your initial decision.

How can we effectively address this challenge and overcome the anchoring effect?

When making a decision to buy or sell a stock, it is essential to fairly evaluate every new piece of information that emerges and could potentially affect your expectations.

It is crucial to set aside your initial anchor and reassess the value of the stock based on current circumstances.

By giving fair consideration to new information, you allow it to compete with your previously established anchor and influence your decision-making process.

The anchoring effect is just one among several biases that exist, but it holds significant importance. I believe I have provided you with the necessary understanding to continue your trading journey and navigate this bias successfully.