Introduction
Anchoring is the utilisation of irrelevant information as a basis for measuring or calculating the uncertain value of a financial instrument, such as the purchase cost of security.
What Anchoring is in Detail
Anchoring is a conduct bias in which the use of a psychological benchmark carries a disproportionately high weight in the decision-making process of a market participant. The concept forms part of the behavioural finance field, which studies how emotions and other alien factors influence economic choices.
One effect of anchoring in the investment sense is that market participants with an anchoring bias tend to hold shares that have lost value because their fair value calculation has been anchored to the original price rather than to the fundamentals. Consequently, market participants take on higher risk by keeping the investment in the expectation that the security will return to its purchase price.
Market participants are often conscious that their anchor is incomplete and try to make changes to represent the information and analysis that follows. Such modifications, however, still produce results that reflect the bias of the original anchors.
Impact of Anchoring Bias
An anchoring bias may cause a participant in the financial market, such as a financial analyst or investor, to make an incorrect financial decision such as buying an undervalued investment or selling an overvalued investment.
Anchoring bias can occur anywhere in the financial decision-making process; from key forecast inputs such as volumes of sales and commodity prices to final output such as cash flow and prices of a security.
Historical values are common anchors, such as acquisition prices or high-water markings. This holds for the values needed to achieve a certain goal, such as achieving a target return or generating a specific amount of net income. These values are unrelated to market pricing and reject rational decisions by market participants.
