Anchoring Bias

When we subconsciously oversimplify something based on that first piece of information, we internalize it as true, and as a result, make arbitrary decisions not based on logic.

Quite simply, take the time to become aware of any anchoring biases you might have when making financial decisions. Start by determining what that first piece of information was and how it might be influencing your decision making.

When making any kind of purchasing decision, our past memories can influence what actions we take. It creates an arbitrary benchmark based on preconceived notions that can result in making decisions based on emotions, not facts.

You can experiment with the stock market by doing an imaginary $500 investment. Consider three stocks you'd like to invest in. Review the stock price history as you determine which stocks to buy. Make the imaginary investment and then watch the stocks for three months. During this time, choose to sell them or hold onto them.

As you do this, concentrate on your thought process. Are you buying or selling the stocks based solely on the highest price you saw in the stock history? By doing so, you are not considering all aspects of the stock like why that happened. As a result, it skews your judgment.

In this instance, you may be experiencing another type of effect called the disposition effect, meaning you hope the stock jumps back to its purchased value (the reference point) to avoid recognizing the loss. If there's no evidence for the stock to gain, you should sell and forget past prices. Say, for example, you might have bought a stock at $35 and you see it drop to $27, then it rises to $32. Since you know the stock was at $35 at one point, you may not want to start selling the stock until it gets above $35.

Sometimes people get attached to investments that have gone up relative to their peers. They focus on the most recent return of a particular investment versus the fundamentals of the investment. Using the "high benchmark" can lead someone to hold onto an investment for way too long. They make an emotional decision versus applying logic.

Financial planner Bill Laipple shared, "We met a prospective client in the late 1990s that invested his entire savings ($200 thousand) in one stock. That stock went up considerably in a short amount of time. When we met it was valued at over $5 million. We suggested that he sell and diversify. We asked him what he would do if we gave him $5 million that day. He said he would spread it out over multiple investments. But, he let his emotions drive his behavior, held on and rode that stock down to nothing."