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anchoring and adjustment Bias

Anchoring and adjustment bias is a cognitive bias where individuals rely too heavily on an initial piece of information, leading to insufficient adjustments when making decisions. This bias significantly impacts financial decision-making, negotiations, and pricing strategies, as illustrated by various real-life and financial examples. The concept, introduced by Tversky and Kahneman, highlights how initial anchors can skew perceptions and expectations in diverse contexts.

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25 views

anchoring and adjustment Bias

Anchoring and adjustment bias is a cognitive bias where individuals rely too heavily on an initial piece of information, leading to insufficient adjustments when making decisions. This bias significantly impacts financial decision-making, negotiations, and pricing strategies, as illustrated by various real-life and financial examples. The concept, introduced by Tversky and Kahneman, highlights how initial anchors can skew perceptions and expectations in diverse contexts.

Uploaded by

cyraa ishfaq
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Anchoring and Adjustment Bias in

Behavioral Finance
1. Introduction
Anchoring and adjustment bias occurs when individuals rely too heavily on an initial piece of
information (the anchor) and make insufficient adjustments based on new data. This bias affects
financial decision-making, negotiations, pricing, and investment choices.

This concept was introduced by Amos Tversky and Daniel Kahneman (1974) in their research
on heuristics and biases.

2. How Anchoring and Adjustment Bias Works


 Step 1: An Initial Anchor is Set
People latch onto an initial value, whether relevant or irrelevant.
 Step 2: Insufficient Adjustment
When making decisions, they adjust away from the anchor but often fail to adjust
adequately.

This cognitive bias is commonly seen in financial markets, salary negotiations, real estate
pricing, and consumer purchasing decisions.

3. Graphical Representation of Anchoring Bias


Graph: Insufficient Adjustment from the Anchor

Imagine an investor predicting the future price of a stock based on a previous high instead of
actual market trends.

Illustrative Graph

Price
|
| Anchored Price ($100)
| ●
| | Actual Market Value
| | ●
| | ●
| | ●
|_________|_______________ Time
T1 T2

 The black dot is the investor’s anchor (previous price).


 The blue dots show actual price changes.
 The investor still expects the price to return to $100 (anchored value), despite market
declines.

4. Examples of Anchoring and Adjustment Bias


A. Real-Life Examples

1. Price Estimation (Retail Shopping)

 Imagine a store displays a "Was: $100, Now: $50" sign. Even if the original price was
artificially inflated, buyers believe $50 is a great deal because their anchor is $100.
 This happens in Black Friday sales, where discounts are based on an original (anchored)
price.

2. Salary Negotiation

 A job applicant asks for $100,000, but the employer was initially considering $80,000.
Due to the higher anchor, the employer might offer $90,000, even though they initially
planned a lower salary.

3. Restaurant Tipping

 If a bill suggests tipping amounts of 15%, 20%, or 25%, diners are more likely to
choose from these rather than calculating their own tip from scratch. The lowest
percentage serves as an anchor.

4. Estimating Population or Age

 If asked, "Is Gandhi older than 100 when he died?", people anchor around 100 and
adjust from there instead of recalling his actual age (78).

B. Financial Examples

1. Stock Market: IPO Pricing

 Example: Facebook IPO (2012)


Facebook was initially priced at $38 per share when it launched. Many investors used
this as an anchor, believing it was a fair value, even though the stock dropped below $20
in the following months.
2. Real Estate Pricing

 A seller lists a house for $500,000, even if market value is $450,000. Buyers anchor
around $500,000 and make offers closer to this price rather than the actual market value.

3. Stock Market Analysts’ Predictions

 Analysts provide earnings estimates for companies. Investors anchor their expectations
around these figures, even if real results suggest otherwise.
 Example: If analysts predict Tesla’s earnings to be $2.50 per share, and it reports
$2.30, the stock may decline even if the earnings are strong.

4. Inflation and Interest Rate Expectations

 If central banks anchor inflation at 2%, people expect future inflation to remain around
this level, even if economic data suggests higher inflation.

5. Foreign Exchange Rates

 If $1 = 100 PKR for years, people perceive anything higher (e.g., 120 PKR) as
overvalued, even if economic conditions justify it.

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