The phenomenon of anchoring bias occurs when people unknowingly depend on an original piece of data when making further decisions. This is an example of a mental shortcut that may have adverse effects in terms of shopping, retirement savings, investing, and bargaining.
People make use of mental shortcuts in their daily lives to process information quickly and make decisions. But these shortcuts can cause bad outcomes when it comes to managing personal finances. The cognitive bias of "anchoring" is what causes people to depend overly on early impressions and numbers for their future opinions and choices. In other words, this early information "anchors" future decisions. Jennifer Itzkowitz, associate professor of finance at Seton Hall University who has studied anchoring bias when it comes to investing, explains that an individual may have a number "stuck in their head subconsciously". Heuristics, which is the term used in psychology for these mental shortcuts, can make complex subjects like finance difficult, and people may feel overwhelmed by too much information. To avoid the pitfalls of anchoring bias, Bradley Klontz, a certified financial planner based in Boulder, Colorado and founder of the Financial Psychology Institute, suggests being aware that this bias exists. Here are some examples of how anchoring bias might affect your financial matters.
Klontz, a member of CNBC's Advisor Council, stated that "anchors" can be either intentional or unintentional. A 401(k) match can serve as an example of an unintended anchor. Companies make decisions on the structure of their 401(k) match that may lead to an unconscious change in people's saving habits. To illustrate, a business might give a match worth up to 3% of its employee's salary, causing workers to assume that 3% is a sufficient amount to set aside for retirement, when it is likely inadequate. On the other hand, employers can use anchoring to increase savings. For instance, Google found that by sending out emails to its staff which suggested relatively high contribution rates (such as 10% or 20%), it caused employees to boost their savings.
Klontz reveals that many retailers exploit the anchoring principle to sway customers' buying decisions. This is typically done when stores promote sales, like reducing the value of a pair of pants from $60 to $30. Shoppers tend to be taken in by this, thinking the new price is a bargain, even if this is not always the case due to frequent store sales. The Corporate Finance Institute provides another example where a customer may view a $100 T-shirt as 'cheap' after they have seen a $1,200 T-shirt first, but they would not have the same impression if it were the only price they saw.
In this example, when planning a vacation, a couple finds tickets to Hawaii for $800 each, and then later find tickets to Puerto Rico for $400 each, which only covers airfare. Despite the lower price of airfare, the couple might choose the Hawaii vacation, since they would end up spending the same amount after taking into account associated costs, such as hotel and dining. Tim Vipond, board chair of CFI Education, explains that "the anchor -- the first price that you saw -- unduly influenced your opinion."
Some mobile apps for investing allure potential customers with the promise of being able to begin investing with just $5, according to Itzkowitz. This marketing tactic is designed to make investing accessible to the public at a low cost, potentially creating an erroneous sense of financial security by anchoring users to a meager savings number, elaborated Itzkowitz. "What people initially commit to spend on their first stock purchase is what they tend to keep spending, regardless of the amount," stated Itzkowitz, who co-authored a research paper recently that examined anchoring behaviors across investment trading platforms such as Stash, Robinhood, SoFi, and Stockpile.
According to the paper, the result of encouraging investors to begin with a micro-investment is that wealth accumulation in this brokerage account is lower due to anchoring bias, a finding that holds across all groups regardless of income, age and gender, according to Itzkowitz.
Companies and people frequently employ anchoring when negotiating, like in wage negotiations or a purchase. For instance, Klontz pointed out that a firm may try to pin a prospective employee to a lower salary when hiring. Any lift from there might seem like a benefit to the applicant, but could be what the employer originally considered. To counter anchoring bias, Klontz suggested consistently questioning financial decisions. "Believe that there are those out there trying to exploit you financially," he said. "Always be suspicious of yourself."
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