One of the challenges of financial planning is its complexity. Not only is it mathematically layered...
One of the challenges of financial planning is its complexity. Not only is it mathematically layered, but it’s also fraught with bias and emotional influence. For most of us, we only scratch the surface of about seven areas of financial planning and allow experts to make recommendations and decisions that will hopefully create a better financial position for us in the future.
When it comes to investing (just one area in about seven), there are loads of biases that can either help or hinder the protection and growth of our assets. This makes asset management and investment planning a constantly evolving landscape and requires several types of niche specialists.
Anchoring is a cognitive bias that often comes into play when we are trying to establish the value of something.
This doesn’t only apply to investing - it applies to commodities and services across the board. Every day, we rely on the anchoring bias to help us form a perception of value, from standing in the fresh foods aisle to standing in a second-hand car lot or calling around to find a plumber to fix a leak.
"People make estimates by starting from an initial value that is adjusted to yield the final answer," explained Amos Tversky and Daniel Kahneman in a 1974 paper. "The initial value, or starting point, may be suggested by the formulation of the problem, or it may be the result of a partial computation. In either case, adjustments are typically insufficient. That is, different starting points yield different estimates, which are biased toward the initial values."
This means that we tend to rely too heavily on the very first piece of information we learn, which can seriously impact the decision we end up making. And, living in a world where we have far more access to information than ever before, complicates our decision-making exponentially.
So - can we avoid it? Well, according to Investopedia, not entirely. Here are some ideas they offer to manage our anchoring bias.
Studies have shown that some factors can mitigate anchoring. Still, it is difficult to avoid altogether, even when we are aware of the bias and deliberately try to avoid it. In experimental studies, telling people about anchoring, cautioning them that it can bias their judgment, and even offering them monetary incentives to avoid anchoring can reduce, but not eliminate, the effect of anchoring.
If you are selling something or negotiating a salary, you can start with a higher price than you expect to get as it will set an anchor that will tend to pull the final price up. If you are buying something or a hiring manager, you would instead start with a lowball level to induce the anchoring effect lower.
Ultimately, if we can’t avoid anchoring, we should at least try to use it to our advantage. In financial planning, we have a process called due diligence. This helps us obtain as much relevant information as possible to a specific decision to help us create a close-to-accurate anchor.
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