Anchoring and Adjustment

How Initial References Shape Our Choices

When it comes to making decisions, we often rely on initial references, or anchors, which significantly shape subsequent judgments and actions. These anchors influence various aspects of our lives, from relationships and shopping habits to financial investments. Let's dive into how this cognitive bias operates and how it can lead to both hilarious and disastrous outcomes.

In non-platonic relationships, the first date often serves as an anchor. If the initial encounter is magical, you might overlook later flaws. On the other hand, a disastrous first date can doom a relationship before it starts, even if the person might be a great match under different circumstances.

When it comes to shopping, initial prices set the stage for what we consider reasonable. A €100 shirt marked down to €50 feels like a bargain, even if €50 is still overpriced. The original price serves as an anchor, distorting our perception of value.

In financial investments, the price at which we first buy a stock can anchor our perception of its value. If we buy shares at €100, we might irrationally cling to that price as a benchmark, even if the market suggests a different valuation. This can lead to poor investment decisions, such as holding onto a losing stock in the hope it will rebound to our anchor price.

Now, before we dive into how initial references shape our choices, I’d like to first tell you how initial references are shaped themselves!

Imagine you went to a soccer game, and the person next to you irritates you to your core by being annoyingly loud and spilling their drink on you while cheering for the players, without even apologizing. You just met them through another friend of yours. Weeks later, you see this person again on a nasty rainy day, and they offer you their umbrella. Will this act of kindness change your first opinion of them? You’re thinking, of course not. But you can’t quite put your finger on why not.

Some believe the answer lies in the fact that bad initial impressions have a more substantial negative effect on people than good ones. At the end of the day, we are all humans, and humans are natural grudge holders, right?

Now do me a favor and picture yourself at the stadium, watching that game again:

Imagine your favorite soccer team introduces a new player at that very game, and you get to see this player play for the first time. Will you remember them better from that game if the ball was passed to them, and they scored a goal or missed the net? In most cases, players will miss the net. And that is precisely why in this case, a positive first impression, i.e., scoring, will have a stronger impact on you.

We usually don’t change our opinion about the annoying person we have just met during the soccer match, because we don’t see people throwing their drinks at us on a typical day at the stadium.

On the other hand, it happens a lot more often when people offer their umbrellas to others on a rainy day; that is one of the simplest ways of showing kindness.

The same pattern is seen in the new player example: A lot of games end up with no score at all, and rarely do we ever witness a game like Brazil vs. Germany in 2014.

Frequency is one crucial key in our initial references. Our brains tend to anchor to rare events and features much easier, faster, and stronger than to more common characteristics. Almost always, these initial “references” shape how we refer to events, places, or even people in the future: that windy day at the stadium, the stinky street, that tall girl from marketing.

Initial references, or first impressions, are powerful psychological anchors. When we first encounter something, our brain processes it using the prefrontal cortex, which is responsible for decision-making and social behavior. This initial impression is often influenced by the release of dopamine, a neurotransmitter associated with pleasure and reward. Our brain essentially "rewards" us for making quick judgments, which can save cognitive energy but also lead to biases.

When we receive new information, the brain undergoes a process called "adjustment," where we modify our initial anchor based on additional input. This adjustment is often insufficient, as the initial anchor remains a strong influence. This phenomenon is tied to our brain's reluctance to deviate from the established anchor, even in the face of contradictory evidence.

Now, as always, let's take a stroll down memory lane, shall we?

History is replete with examples of poor decisions driven by faulty anchors. One infamous case is that of New Coke in the 1980s. Coca-Cola, in an attempt to rival Pepsi's sweeter taste, introduced New Coke, which was an initial hit in taste tests. Anchored by the positive first impressions, the company launched it nationwide, only to face a massive backlash from loyal customers who preferred the original formula. The debacle forced Coca-Cola to revert to its classic recipe.

Another example is the DeLorean DMC-12, a car that became iconic for its role in "Back to the Future." John DeLorean's ambitious project anchored investors' hopes on his vision of a futuristic, stainless-steel sports car. However, production issues, high costs, and underwhelming performance led to the company's bankruptcy, leaving a stylish but flawed piece of automotive history.

Anchoring doesn't just affect financial decisions; it can lead to some pretty ridiculous outcomes in other areas too. Take the Trojan War, for example. The Greeks' initial belief in the effectiveness of the Trojan Horse anchored their strategy, leading to the epic fall of Troy. The Trojans' initial acceptance of the "gift" without suspicion shows how powerful and misguided anchors can be.

In a more light-hearted example, consider the fashion industry. Remember shoulder pads in the 1980s? The initial impression that broader shoulders equated to power and fashion led to some truly bizarre clothing choices. Looking back, it's hard not to chuckle at the exaggerated styles that seemed so chic at the time.

In the world of finance, bad anchors can lead to devastating outcomes. I’ve referenced this in the “Fear Factor” chapter, but it’s just one of those pages in our history book that, in my opinion, could easily earn an honorable mention in several other chapters: The 2008 Crash.

The housing market crash serves as a prime example, illustrating how poor financial decisions can ripple through the economy. Initial home price surges anchored the belief that real estate was a foolproof investment. This led to risky lending and borrowing practices, ultimately resulting in a catastrophic market collapse.

Another case is the Enron scandal. Investors' initial impressions of Enron as a high-flying energy company anchored their perception, blinding them to the company's fraudulent activities. When the truth emerged, it caused a financial earthquake, wiping out billions in investments and shaking trust in the market.

The moral of these stories, you ask?

Anchoring and adjustment play a significant role in shaping our decisions, from the mundane to the monumental. Whether in love, shopping, or investing, our initial references can lead us down paths both glorious and disastrous. Understanding this cognitive bias is the first step in mitigating its effects.

Consider the impact of anchoring in contract negotiations and salary discussions. Imagine a working student expecting a wage of €15 per hour but receiving an initial offer of €12. This lower anchor might cause them to settle for €13, even though they initially believed €15 was fair. Conversely, if the initial offer was €20, they might end up accepting €18, feeling more satisfied despite it being higher than their original expectation. This example shows how initial anchors can lead us to accept less than we deserve or leave money on the table. Anchoring can also make us miss out on opportunities. For instance, if you perceive a house priced at €400,000 as too expensive based on an anchor of €350,000 from a different neighborhood, you might dismiss it despite its true value being higher. This clouded initial judgment could prevent you from making a sound investment or finding your dream home.

One effective way to use the right anchors is to strive for factual and unbiased observations, seeing things for what they are rather than what they have been. This brings to mind the secret to factual judgment. Austrian physicist Erwin Schr?dinger, in 1935, describes a paradox as an experiment that helps illustrate my point. He says: "If we leave a cat and something that could kill the cat in a sealed box, there is no way for us to know if the cat is alive or dead unless we open the box. Until then, the cat is both dead and alive."

Schr?dinger's cat reminds us of the uncertainty and the need to “observe and assess” situations without preconceived notions. Being mindful of our anchors and willing to adjust them when necessary is crucial. Just as Schr?dinger’s experiment shows the necessity of opening the box to understand reality, we must open our minds to reassess our anchors. So, next time you see a “sale” sign, before getting too excited that the price has gone down from €120 to €60, check the brand, its quality, and real value. Touch the fabric, try it on. Does it even look good? Do you need it? Do you even like it? A simple sale sign cannot and should not make you spend money on something you don’t need, most probably don’t like, and, God forbid, do not look good in.

A written number on your new contract should make you neither excited nor disappointed. What do you think you’re worth? Have you done your due diligence? Have you done the math? Do you even know how much you want, need, or are worth? While anchors influence our decisions, we must be vigilant, exact, flexible yet sharp in our assessments.

And lastly if I may:

As the disclaimer at the bottom of each investment fund PowerPoint presentation has taught us, "Past performance is no guarantee of future results."

Note of the month: Anchoring bias skews judgments, but the eyes that saw clearly belonged to those who wielded a status quo mindset and a clean slate vision.

Beyond The Numbers is a monthly newsletter that aims to delve into the human side of finance, exploring emotions, psychology, and biases that influence our financial decisions. My name is Sadaf Poursheikhani, and I am a behavioral economist, passionate about dissecting investor psychology. Join me as we uncover the hidden secrets of the financial world.

Disclaimer: I would like to remind readers that this newsletter is based on scientific studies, my own research, and personal opinions. It does not reflect the views of any organization, and I am not providing financial advice. Rather, the aim is to shed light on the emotional side of the market and provide insights into how emotions can impact financial decision-making.