Anchoring in Trading
Sometimes we make rash decisions without thinking. We might feel like we had a very good basis for taking the action, but the final results are still disappointing. One of the reasons this happens is anchoring. Anchoring can affect our decision making process and mess with our perception of our actions.
In this article, you will learn about what anchoring bias is, what causes it, why it is dangerous, and how you can prevent it from influencing your trades.
What is anchoring?
Anchoring is a psychological bias that happens when the information a person is presented with is accepted as the main point of reference in further decision making. This piece of information, or an “anchor”, overshadows any additional data that might come up later on and influences how the person thinks about a problem, even if the information ends up being irrelevant in this particular case.
Anchoring bias is a concerningly widespread issue in trading. It’s not rare for traders to hold on to the positions that are costing them money if they believe the current prices aren’t fair or satisfactory compared to the prices they spent on acquiring the asset earlier.
How does anchoring happen?
Anchoring is often used intentionally as a way to push people into making the decision the offeror wants them to make. For example, this strategy is widely employed in car dealerships when the price a buyer ends up agreeing to ends up being lower than the price a seller has asked initially. The buyer leaves feeling like they got a good bargain. In reality, this was a premeditated move on the seller’s part. Setting the initial price higher than the actual price of the vehicle, the seller takes advantage of the buyer’s inability to critically analyze the offer under current circumstances. The buyer ends up settling on the option they think is more lucrative at the moment, even though they might realize they could have found a better offer if they’d had more information (after visiting other dealerships and comparing the prices, for instance).
However, anchoring can also happen unintentionally, when people subconsciously take the first piece of information available to them as the only true and credible source to base their final decision on. For instance, finding that the average price of a car they want is $10 000 may make them think that a price of $8500 means there are some underlying potential problems with it, causing them to miss out on the opportunity to save money on their purchase.
How anchoring bias impacts trading and investing
When it comes to trading or investing, anchoring bias can really deceive people. It can cause a trader or an investor to make a wrong financial decision, buying an asset for more than it’s actually worth or selling it for less than would be possible. Anchoring is one of the main reasons behind poor financial decisions on the part of traders and investors.
For instance, if you bought stocks for $100 without researching the market fundamentals like the company’s growth rate potential, earnings etc., you might not be able to sell it for much more, or even earn anything at all. If the price of the stocks falls below $100 and continues to drop, you may feel reluctant to let it go and continue holding it, hoping for the price to go back up. However, the initial price of $100 could as well have been an error. Not knowing this, you let yourself get anchored by the first price you saw and overvalued your purchase. This happens to a lot of people working on the financial markets, but it doesn’t mean they are conscious of these anchors that prevent them from making successful trades.
Historical prices, financial indices, volume of sales, high-water marks are among the most common anchors. Using them as the focal point of reference for making financial decisions can lead to eventual disappointment.
Causes of anchoring bias in trading
There are various reasons for why anchoring creates so much trouble for traders. Here are the main causes that make traders commit to losing positions, whether consciously or unconsciously.
Lack of experience
When beginners take their first steps on the path of trading, they might feel overwhelmed with all the information they need to keep track of. It takes time to learn how to interpret and evaluate the market data. That’s why it’s so tempting to just make decisions based on the first information they receive. However, whether it turns out relevant or not is another question entirely.
Everyone has their own opinions and beliefs. This is why a lot of traders tend to believe the information that falls in line with their existing expectations about the market. When it happens, it is hard to objectively assess the information, especially when there’s data contradicting a trader’s views and preferences. This causes them to eagerly accept the anchor and make decisions that can later bring them disappointing results.
It’s not rare for traders to get attached to their trades. They start “rooting” for them, holding out hope that the price moves in the direction preferable to them. However, getting emotionally attached to positions means they’re not able to objectively analyze the market and make the best decisions concerning the assets in their possession.
Another way to fall into the trap of anchoring is by basing all trading decisions on average estimates or one analyst’s opinion. With trading, one needs to research a topic from multiple perspectives and hear different opinions. Taking information from only one source and especially average estimates at face value can prevent you from considering other circumstances that can influence your trades.
How to avoid anchoring bias in trading
Anchoring can be dangerous to both traders and investors as it makes them base their actions on the first piece of information they manage to glimpse on the market.
In order to avoid anchoring bias in trading or investing, you should consider using the following strategies:
- Keep up with the news. Following the news from the market can help you avoid anchoring to outdated information. With FBS you can learn about the latest trading news faster than anywhere else and better navigate through the constant changes on financial markets.
- Focus on long-term outcomes. It’s easy to anchor to the current price when all you think about is short-term gain. However, when you focus on long-term results, you’re more likely to factor in any potential price fluctuations that may occur on the market.
- Develop a strategy. A well-developed trading strategy can provide you with a set of rules and guidelines that can help you avoid anchoring. With an established system, you’re less likely to fall victim to your emotions and more likely to stay objective while making decisions.
- Check multiple sources. Hearing different opinions from multiple sources can help you avoid anchoring and stay unbiased when opening new trades.
- Stay concentrated. Staying concentrated and being mindful of your thoughts can keep you from anchoring or falling victim to other cognitive bias. You can try meditating to free your mind from emotions and alleviate stress.
How to use anchoring bias to your advantage?
There is a way to use anchoring in a way that can help you. If you’re selling something or negotiating a salary for a new job, you can name a higher price at first. This will create an anchor in another person’s mind, so your next offer will sound like a bargain to them.
Anchoring can be very destructive when it comes to trading. Learning how to handle your bias and use different sources of information can help you become a more successful trader and understand the market better.