The Role of Anchoring Bias in Decision-Making
Did Marilyn Monroe die at the age of 98 or older?
For the ones who don’t already know Marilyn Monroe’s biography, the answer to this question will likely be a pretty high estimate of the age she passed away… perhaps rightly, perhaps wrongly.
In a 1974 research paper “Judgment under Uncertainty: Heuristics and Biases”, Kahneman and Tversky conducted an experiment where participants were asked to spin a rigged wheel that only stopped on 10 and 65. Afterwards, they had to guess the percentage of African American nations in the UN. Results showed that despite the irrelevance of the wheel, participants response was highly influenced by the number which they scored. The average guess was 25% for those who landed 10 on the wheel, and 45% for those who scored 65.
This phenomenon is called the anchoring effect – a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered – the “anchor” – when making decisions or assigning a value to an unknown quantity. Anchoring occurs when individuals use an initial piece of information to make subsequent judgments. Once an anchor is set, judgments are often made in relation to that anchor, resulting in a biased interpretation of the information around the anchor.
Behavioral Economics explains why people sometimes make irrational decisions and how our limited cognitive ability can affect our decisions. According to Kahneman, the human brain can be seen as a hardware, which contains 2 types of software: System 1 and System 2. The former is fast, effortless, impulsive and used in everyday decisions, while the latter is slower, effortful, thoughtful and used in more complex and important decisions. According to behavioral economists, humans tend to choose the least resistant path while making a decision. This tendency leads to the preference of System 1 over System 2 and, as a result, makes us rely on heuristics. Heuristics are shortcuts that allow us to quickly jump to adequate but sometimes imperfect decisions.
The anchoring effect may, therefore, be classified as a heuristic which can appear under both types of cognitive systems. Coming back to the initial question, the anchoring effect under the fast, impulsive, and subconscious-driven System 1 will bring us to the conclusion that maybe Ms. Monroe did not live for 98 years, but certainly she was pretty old when she died. Conversely, an “anchoring” question referring to a premature death would have led us to guess a younger age. Under System 2, we will start from the anchor and then structure our thoughts (When did she live? What was the life expectancy at that time?) to eventually move away from the anchoring value towards a more thoughtful estimate.
The anchoring effect in finance, economics, and everyday life
In economics, the initial price offered, for instance, for a used car sets the standard for the rest of the negotiation. Therefore, a price lower than the initial offer seems attractive even if it’s still higher than the true worth of the car. Similar behavior can be observed in everyday purchases, such as online purchasing or shopping at a supermarket.
In finance, the most common anchoring bias is neglecting the inflation rate at the starting point in the valuation of an investment. A bond which guarantees the payback of the capital plus an annual 2% interest rate for 5 years might reveal to be a bad investment since it’s unprotected from decreasing purchasing powers (rise of inflation rate) over the years. Similarly, while trading/investing in equities, investors usually consider the purchase price as the benchmark of their stock performance. Thus, they will be pushed to keep the stock while price is decreasing compared to the anchoring (purchase) one, or to sell them untimely to consolidate the profits as soon as they increase a bit. In other words, their portfolio management choices are driven by psychological feelings rather than financial analysis.
In everyday life… Have you ever gone to a restaurant and was told that the waiting time is 30 minutes? The number 30 has created your psychological zone of what is acceptable. In this case, when the waiting time turned out to be 20 minutes you were very pleased. Had you been told the waiting time is 10 minutes, you would have been increasingly frustrated by waiting for the same 20 minutes. The difference here was not in the actual waiting time, but in the anchor suggested.
So, the next time you are trying to make an important decision, give a little thought to the possible impact of the anchoring bias on your choices. Are you giving enough consideration to all of the available information and all of the possible options, or are you basing your selection on an existing anchor point?
P.S. Marilyn Monroe died at the age of 36.