Anchoring and Adjustment

What are Anchoring and Adjustment?

Anchoring and adjustment refers to the cognitive bias wherein a person is heavily dependent on the piece of information received initially (referred to as the “anchor”) while making all the subsequent decisions. In other words, all the subsequent decisions are influenced and require adjustments to remain close to the initial anchor value, which can be a cause of a problem if the anchor is too different from the true value. This type of bias typically is seen when an individual builds future outcomes based on past available information.

Explanation

Anchoring and Adjustment

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During the decision-making process, a person is said to be exhibiting anchoring and adjusting behavior when all their decisions are heavily influenced by the initial set of information. Typically, the individual would tend to integrate all those ideas that fall within the acceptable range of the anchor and reject those that are not in line with the anchor. So, in all forthcoming arguments, negotiations, estimates, etc. only those values are discussed that are close to the anchor.

Basically, the underlying principle of anchoring and adjustment is that an individual tends to choose a particular value or number as the starting point (a.k.a. the anchor) which eventually becomes the target number and subsequently the individual ends up adjusting the following pieces of information until it reaches within an acceptable range of the target value over the period of time.

Mechanism

As already discussed above, anchoring is a type of cognitive bias wherein an individual relies too much on facts that are provided prior to the decision making process with the objective to help the process. There are instances that the facts that are provided are entirely useless or even absurd. Nevertheless, research stats indicate that these initial set of information significantly impact the decision making process irrespective of their relevance to the subject matter. While anchoring is believed to be a semiconscious or subconscious phenomenon, adjustment about the anchor is a totally conscious decision.

The underlying mechanism that drives the anchoring and adjusting effect can be linked to the following two concepts:

  1. Anchoring via Suggestion: In this type of anchoring, the initial set of information can be compared to a suggestion. Once a suggestion is made based on some association, it becomes the basis for all estimations that follow, and adjustments are made on the basis of the same. It forms the basis of semiconscious anchoring.
  2. Subconscious Anchoring: In this type of anchoring, an individual has little to no association with the anchor. At times these anchors are incorrect. In this case, the person believes that the anchor is correct or, at times, acknowledges that it might be incorrect but believes that it is still worth it to stick to the anchor. Eventually, the individual makes all the adjustments in order to hold on to the anchor.

Anchoring and Adjustment Examples

  • Example #1 – Let us take the example of a used car salesman to illustrate the concept of anchoring and adjustment. Usually, the salesman would quote a very high price to start the negotiations, which is undoubtedly well above the market value of the car. Now, the initial price quoted by the salesman becomes the anchor, and as such, the buyer invariably would end up paying a final price that would be much higher than the fair value. This was only made possible by the car salesman by creating an anchor with a higher quote.
  • Example #2 – Let us take another example of a hiring manager to illustrate the concept of anchoring and adjustment. During hiring negotiations, a hiring manager might consider offering a very low compensation package to a prospective candidate. Now, because of the lower starting point, the candidate, even after several rounds of negotiation, might end up joining at a relatively lower initial salary.

Anchoring and Adjustment Heuristic in Finance

In the field of finance, anchoring and adjustment are seen when an analyst builds an economic forecasting tool or a pricing model. The cognitive bias creeps in when an analyst tends to build the financial modelsBuild The Financial ModelsFinancial modeling refers to the use of excel-based models to reflect a company's projected financial performance. Such models represent the financial situation by taking into account risks and future assumptions, which are critical for making significant decisions in the future, such as raising capital or valuing a business, and interpreting their impact.read more based on a single big idea that fails to take into account many other related and relevant factors. The best modus operandi to mitigate the risk of anchoring is to assimilate the approaches of multiple models.

According to Phillip Tetlock, a social psychology researcher, the forecasters who make their predictions on the basis of multiple ideas or perspectives are able to build better forecasting models compared to those who emphasize on a single model. In short, an analyst can make his work less vulnerable to anchoring effects by incorporating the best of different models and forecasts into their model.

Disadvantages

  • In case the initial anchor value is not adjacent to the true value, then all the subsequent adjustments due to bias towards the anchor value will take the outcome away from the true value.
  • At times the anchor value is totally different from the true value, and in such cases, the individual might be caught in the conundrum of drawing connections between the irrelevant initial information and the true value.

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