Anchoring

Anchoring is the tendency to rely too heavily on the first piece of information you see, or on one reference number, when making a judgement. Psychologists Amos Tversky and Daniel Kahneman showed in the 1970s that even random numbers can shift people's estimates. In trading, anchors are everywhere: the price you paid, a stock's all time high, a target from an analyst, last year's level or a round number.

The classic experiment#

In a well known 1974 study, Tversky and Kahneman spun a wheel of fortune rigged to land on either 10 or 65, then asked participants to estimate the percentage of African nations in the United Nations. Those who saw 10 gave a median estimate of 25%; those who saw 65 gave a median estimate of 45%. A number they knew was random changed their answers by 20 percentage points. If a meaningless number can do that, a meaningful looking number such as your entry price can do far more.

Common anchors in trading#

When reference levels are useful#

Not every reference number is a bias. Many traders watch prior highs, lows and round numbers because other traders watch them too, which can create real buying and selling interest at those levels. The difference is in how you use them:

• Useful: "Many orders may sit near the prior high, so I expect a reaction there." See Support and Resistance and Psychological Levels.
• Anchoring: "It used to trade at the prior high, so it must go back there."

A level is a place to watch for a reaction, never a promise that price will reach it.

Anchoring and updating#

Anchoring also makes people adjust too little when new information arrives. Analysts and traders who start with a forecast tend to revise it in small steps, even when news calls for a big change. This slow adjustment is one explanation offered for effects like Earnings Reactions and Post-Earnings Drift, where prices keep moving in the direction of an earnings surprise for weeks after the report.

The same thing happens in your own trading. If you decided last week that a market was bullish, you may read this week's weak data as a temporary blip instead of a reason to change your mind.

How to reduce anchoring#

1. Judge positions on current value, not on your entry price. See Sunk Cost Fallacy.
2. Ask what has changed before using any historical price as a reference.
3. Use valuation, not past price, when asking whether something is cheap. See Valuation Basics.
4. Make a range of scenarios rather than a single target.
5. Write down what would change your view, and update fully when it happens. See Confirmation Bias.
6. Measure risk in percentages of your account, not against a past peak balance. See Maximum Drawdown.

Common mistakes#

• "It was $X, so it's cheap now."
• Refusing to sell below the entry price.
• Treating a price target as a promise.
• Sizing up to win back a past account high.

Frequently asked questions#

What is anchoring bias in trading?#

Relying too heavily on one reference number, such as an entry price or a past high, when judging what a market is worth or where it will go.

Are support and resistance levels anchoring?#

They can be used sensibly because many traders watch the same levels. Anchoring is assuming price must return to a past level without a current reason.

How can I avoid anchoring?#

Focus on current information and value, consider several scenarios and update your view fully when new evidence arrives.

Next, learn how hindsight distorts the way you judge past decisions in Hindsight and Outcome Bias.

Sources#

• Tversky, A. and Kahneman, D., Judgment under Uncertainty: Heuristics and Biases, Science, 1974. Summary: Wikipedia, Anchoring effect