Do you know what anchoring bias in finance means? It’s an irrational fixation on price, information or trading direction that is detrimental to traders. Are you looking for someone to blame for your not-so-stellar day trading performance? Try checking the mirror. When it comes to money, decisions aren’t always rational, even when we think we’re logical. Have you ever sold winning trades too soon? What about holding on to losers for too long hoping and praying the price is going to go up. Here is one common human error in trading we’re all susceptible to. Keep reading and take notes; I will show you how to prevent anchoring bias in trading.
Imagine this scenario: you inherit a painting from your late grandmother’s estate. Attached to the painting on the back is a handwritten note saying it’s worth $5 million. A little bit of time passes, you lose your job and find yourself in a tight spot financially. You then decide to put the painting for sale. A collector offers you $1 million for the piece; you turn it down immediately because you “know” it’s worth $5 million.
Fast forward a few weeks later, a museum calls and makes you an offer of $6.3 million for the painting which you happily take. Not long after, you discover it’s worth at least $12.5 million. How do you think would you feel? Well I think its safe to say you will feel very crappy for leaving money on the table. Whereas instead of you feeling like you’d made a profit, you’d feel foolish knowing there was an opportunity to earn way more.
What I explained above is an example of a psychological trap known as anchoring bias. Unfortunately, anchoring bias in finance happens when you give more weight to the initial piece of information (the anchor) when deciding which action to take.
Researchers have found dozens of unconscious biases that can drive people to make all crazy sorts of decisions – money included, they later regret.
Take the behavioral economics concept known as “anchoring” for example. In fact, anchoring is one of the most potent and dangerous phenomena in trading.
Anchoring bias in finance is the use of irrelevant information, such as the purchase price, as a baseline for evaluating or estimating an unknown value of a financial instrument.
Put simply, anchoring means that people tend to see recent price levels as the fair price for their stock. Unfortunately, they ignore or at least are slow to incorporate new information.
Anchoring bias in finance can take on several forms. Let’s look at a stock that’s been trading around $100 a share for the last year. Since that’s the price, we tend to think of $100 as a fair value for that stock. Consequently, we don’t take into account the fact that they announced high earnings last week.
Or, that they did a transformative deal or something similar. For example, pretend that you own stock in both ROKU and Tesla stock. If ROKU stock rises from $100 to $200, and Tesla has fallen from $150 to $80, what do people do? Well, they think, “Oh, Tesla’s so cheap here, it’s definitely going to come back. And ROKU’s gotten too expensive, it’s going to fall.”
Then they act accordingly. You get it. They sell ROKU, which is doing well fundamentally without taking the time to analyze it. ROKU doesn’t fall, nor does Telsa recover. They’d see that Telsa wasn’t a deal because the fundamentals don’t support a comeback; it hasn’t hit rock bottom yet. But nope, once again, a decision was made irrationally, and they bought Telsa in error.
If you find yourself having a specific and perhaps arbitrary number in mind that sways your decision-making, you’ve fallen prey to anchoring. Another scenario might be buying a stock that briefly rose from trading around $65 to hit $80 and then fell back to $65, out of a sense that it’s now a bargain (anchoring your strategy at that $80 price).
What about selling Facebook just because the company’s stock hit a round number, like $300 a share. Or, worse yet, the “endowment effect.” This phenomenon can cause you to overvalue something simply because you own it. The end result, you to cling to a stock that’s tanking.
Historical values, like acquisition prices or high-water marks, are common anchors. Likewise, one of the most common anchor traps in investing is past events and trends. Investors look at the historical values of a particular stock, become anchored to them, and base investing decisions on them.
In this scenario, past figures show the historical prices of the stock over a certain time period. But they will definitely fail to capture the rapid changes in the market. So this could cause quite an anchoring bias in finance.
Anchoring bias in finance will absolutely affect your decision making because you’re irrationally fixated on one thing. For example, I really like the “Ride the 9” strategy in trading. It’s a strategy in which you use the 9 EMA to get in and out of a trade. And while in that trade, you ride price up or down. Now if I became so fixated on trading that way, that it affected how I got in and out of trades, I’d bet money I’d be a terrible trader and one of the 90% that fails. Being so obsessed with one way of doing things can cripple your trading.
In the context of trading, one consequence of anchoring is that traders tend to hold stocks that have lost value. I would say this is because they anchored their fair value estimate to the original price rather than to the fundamentals. You might have heard this referred to as “bag holding.” These so-called “bag holders” assume a greater risk by holding and the stock will return to its purchase price.
Traders are often aware that their anchor is faulty, and they attempt to make adjustments to reflect subsequent information and analysis. However, these adjustments often produce outcomes that reflect the bias of the original anchors.
But I’m smart. I won’t fall victim to Anchoring bias in finance. You may be smart, but 1,000’s of years of conditioning have caused the human brain to form estimates naturally. When you think about it, it’s pretty hard to decide without having estimates or any comparison about its worth.
By the same token, the leading cause of anchoring is uncertainty. In the face of uncertainty, it is normal for one to determine value based on past historical information.
The best way to overcome the psychological trap of anchoring is to be aware of it. Like anything in life, awareness is the first step to reduce the chance of using anchoring when making decisions.
Undoubtedly, once you are aware, you can build habits into your trading strategy that allows you to overcome the bias.
Seeing as humans are prone to giving disproportionate weight to the initial information one receives, a great way to overcome anchoring bias is to do your research.
In other words, do your due diligence. I suggest you look at the facts from various perspectives. Keep questioning the so-called “facts.” How do you know they are accurate? Gather the evidence, compile it and make your decision based on well-researched information.
For these reasons stated above, I can honestly say that making a good investment and trading decisions require rational and logical thinking. When we take the time to examine bad choices (i.e. losing trades), we can usually trace them back to the way we made the decisions.
Perhaps you didn’t follow a strict trading plan with specific trading criteria. When you fail to identify the why and fail to engage in critical thinking, you tend to easily fall victim to this hidden trap in decision making.
At the end of the day, your job as a trader is to protect yourself. Don’t be your own worse enemy when day trading. Don’t let anchoring bias in finance make you a bad trader.