Today’s cognitive bias is anchoring and its not only something I try to avoid in investing, it’s also something that I exploit in negotiations.  And you can too!  

When you’re negotiating and you know the inherent value of something, you can easily barter a fair price.  But when you’re unsure of an item’s value and the other person first names a selling price, you’re more likely to “anchor” your counter offer somewhere in the vicinity of their price.  Anchoring is a cognitive bias that describes our human tendency to rely too heavily on one trait or piece of information.  Any secondary adjustments are usually made relative to the “anchor”.

 Let’s say you’re at a flea market and you want to buy a “beechin” (or a widget).  Beechin’s are worth $10 a piece but you don’t know that.  When you walk up to the beechin vendor, he a) smiles politely and asks for $10 or b) smiles politely and asks for $50.  Now, human tendency is to anchor our counter offer to that original price (I would counter $7 for scenario “a” and $40 for scenario “b”).  Another great example is from MIT professor Dan Ariely.  He did a study where he asked a group of people to write their last 2 social security digits on a piece of paper.  Then, he asked them to write down bids on items such as chocolate or wine.  When sorting through the data, he found that people that had higher social security numbers were more likely to bid 60%-120% more on the items.  They took a totally arbitrary piece of information (SSN) and anchored an unrelated number to it because their minds were connected to the first number.

We can use this new found knowledge of anchoring to become smarter investors.  Let’s say we want to invest in Apple (AAPL) stock back in the winter of 2007 when it was trading at close to $200 a share.  If we knew nothing else about the stock or company or market and we saw it had dropped to $165 a share in one days trading, we may be persuaded to buy up shares.  Our minds tell us that since it was $200 and is now $165, it must be a good deal.  What we may not be taking into account, however, is that $200 may be an arbitrary number that does not accurately reflect the value of the stock (see tech bubble burst).  I’ve talked to countless people that knew nothing else about investing, but thought that a stock was a good deal solely based on the fact that it was a lot lower than a past price.  What’s the mantra of investors and financial planners worldwide?  PAST PERFORMANCE DOES NOT INDICATE FUTURE EARNINGS!  We have to make sure not to be swayed by unrelated information when making our investment decisions.  Probably the best way to avoid anchoring is by being an informed investor.  As long as we know the true value of something, we can never be pushed into something that is not in our best interest.  Whether in your negotiations or investing or life, what are all of your anchoring examples?

Tomorrow…  Framing!