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In the financial markets, there is usually the tendency to rely on a single piece of information to make a trading or investment decision. In most cases, the buying and selling that takes place is anchored on a single piece of information, regardless of whether it needs to be updated or corrected. Such kind of behavior is often dubbed as anchoring bias.
Anchoring bias is a behavior or tendency whereby traders place importance on the previous price or the first piece of information they receive to make decisions. As a result, the information is relied upon regardless of being correct or incorrect, often exposing traders to significant risks. In this case, the anchor information acts as the reference point from which future decisions are made.
Therefore, it prevents people from making informed or rational decisions whenever certain data points change, or new information exists. In the investment world, anchoring leads to traders chasing trades.
An anchoring basis also causes investors and traders to make bad decisions and chase first investments rather than looking for better alternatives. The cognitive biases also make adapting to the changing market environment challenging.
In trading, anchoring bias takes many forms.
Consider a trader who opens a buy contract on the S&P 500 Index at the start of a trading day on the market showing signs of edging higher. The trader holds the position based on the information used at the beginning of the trading day, regardless of what transpires in between. Even on the market showing signs of exhaustion and potential reversal, the trader refrains from selling the contract as their beliefs and decisions are anchored on the initial information about a bullish run and don’t wish to consider anything else.
Another trader buys Tesla stock based on price hikes and the belief that the company is poised to dominate the electric vehicle space for many years to come. Given that the trader is anchored on previous performance expectations and price hikes, they would be reluctant to sell even if the price starts to tank. Changing market trends and increasing competition in the EV space don’t sway the trader to exit the market as their trade is anchored on the previous information.
Studies have shown that the human brain tends to anchor new information as it makes it easy to make decisions. Therefore, traders make trading or investing decisions based on the anchor information imprinted in their brains.
In most cases, anchoring bias in trading causes traders to use first impressions to make decisions or form further perceptions. Therefore, it might be found at any point in the trading decision-making process.
Source: CMT Association
Anchoring bias affects trading in various ways. First, it could lead to emotional attachment to prior prices or positions. In this case, one would make buy or sell decisions based on past prices.
Suppose a trader is strongly convinced that a given stock's price should be $200 based on previous information. In that case, they will make a buy decision after a significant sell-off, even if underlying metrics indicate the stock is overvalued.
Similarly, a trader may open a sell position on a stock if they strongly believe it should trade at $200 after a significant price increase. The trader would open a sell position even if current metrics and fundamentals indicate it is still undervalued, as the focus is on previous information rather than new data.
Despite the significant risks anchoring bias presents, it happens daily, affecting professional and novice investors and traders equally. The bias occurs due to the following:
Whenever traders are under immense pressure and time constraints to make investment decisions, most base their decisions on previous data. Traders rely heavily on initial prices and data instead of conducting in-depth analyses and analyzing current fundamentals. The anchoring bias may result in the traders making incorrect decisions that hurt their portfolios.
Anchoring bias may also come into play in the absence of new information that traders can use to make informed decisions. Consequently, traders need to adjust their valuation based on new information, Such as changing market conditions. Instead, trades and investments are made based on the initial price that acts as the anchor or strong convictions.
It’s the tendency to seek and rely on information to confirm existing beliefs. Ultimately, trades are made based on this information, which is extremely biased. Therefore, ignoring information that contradicts existing beliefs presents significant risks when it comes to making decisions.
One of the biggest risks in trading is having an emotional attachment to a given stock or an underlying price. The attachment often leads to anchoring bias as decisions would be made based on previous experiences and prices rather than current information. For instance, a trader may be unwilling to close a position even on new information implying they should because they have an emotional attachment to the previous price. Consequently, traders should always watch out for fear, greed, and regret, as they can lead to anchoring bias.
Anchoring bias presents significant risks when trading the financial markets. Any trading decisions should be based on current information and not anchored on previous data or prices. While it can be challenging to avoid anchoring bias, one can do a few things to avoid its pitfalls.
First, it is important to acknowledge anchoring bias by asking questions to ensure decisions are not emotionally driven or based on previous information or data. Always consider all available information and options while trying to buy or sell.
While making trading decisions, it is essential to consider all alternative scenarios rather than being fixated on a particular reference point. In addition, seeking and analyzing diverse sources of information rather than relying on one data point could also help avert the anchoring bias risk.
Additionally, traders must resort to rule-based trading rather than making impulsive or irrational decisions. Finally, diversifying an investment portfolio helps avoid becoming too attached to a given investment or position.