The phenomenon which we are going to study is so common and simple that we just ignore how it can affect your day to day life decision. It is most solid tested phenomena in the world of experimental psychology. It is called Anchoring Effect.

To get the idea of this effect, take a sheet of paper and draw a 2.5 inch line going up, starting at the bottom of the page- without a ruler. Now take another sheet and start at the top and draw a line going down until it is 2.5 inches from the bottom. Compare the line. There is a good chance that your first estimate of 2.5 inch was shorter than the second.

This phenomenon was first observed by the father of behavioural finance Daniel Kahneman who conducted a good number of experiments on this concept and you can find conclusions of his experiments in his Nobel Memorial Prize winning book “Thinking Fast and Slow”.

Anchoring effect is a cognitive bias which takes place when we consider a particular value of an unknown quantity before estimating such quantity. The value we have considered or that have been shown to us before, strongly determines the estimate we are going to make, which will always be relatively close to that previous value, which is called the anchor. In the previous demonstration our first estimate or anchor was the first line we drew. Once the anchor has been established, we evaluate whether it’s high or low and then we adjust our estimate to that amount. This mental process finishes early, because we are not sure of the real amount. Therefore, our estimation is not usually far from the anchor. We have a huge tendency to use the small pieces of information that we are offered to trigger decisions and estimates.

There are multiples examples where anchors are created in our daily life’s which influence our buying decisions. Say you’re buying a used Maruti Swift Dzire, the initial price offered by the salesman is Rs 4 Lakhs, and this sets the standard for the rest of the negotiation, regardless of the legitimacy of the initial price. This way any price lower than the initial anchor price seems a bargain, even if the initial price is higher than what the car is really worth. If the salesman can get you anchored on the higher price the consumer will estimate that the lower price is a good deal.

In case of stock markets, suppose price of ABC Ltd. is Rs 38. The last fiscal year company has had bad year. Investors remember last year and opts not to invest in ABC Ltd. If price of ABC Ltd starts moving up from Rs 38 to Rs 105, investor remembers Rs 38 and finds ABC Ltd stock expensive. Same investor when price of ABC Ltd drops to Rs 85 from Rs 105, finds ABC Ltd stock reasonable to "BUY," here investor has in mind price of Rs 105. Mind you this is the same investor who did not purchase ABC Ltd at Rs 38.

Whatever the reason for it, the anchoring effect is everywhere and is difficult to avoid. That’s especially true when we are deciding what to pay for a product since we are overly influenced by the price that’s been set. When it comes to avoiding anchoring, there's no substitute for rigorous critical thinking. Be especially careful about which figures you use to evaluate a stock's potential.

Now that you have understood the concept of anchoring, next time whenever you watch KBC in night with your family make sure to observe the sequence of choices they give in their questions.

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