Anchoring

Definition: Anchoring occurs in financial markets when people seek to match the price (or volume) of an initially sold element at a price lower than they ultimately receive.

Anchoring occurs when people disproportionately focus on an outcome and discount all other possible outcomes. It leads people astray into thinking that goals are harder to achieve than they are—or they can get things done more quickly than they can get things done.  This is especially harmful in finance because it leads people to chase results without regard for whether the results are realistic.  By anchoring your beliefs, you naturally place more importance on initial outcomes than long-term success or failure.

Anchoring is a tactic used in sales discussions to retain your attention and influence others to your point of view. It’s most often seen in negotiation settings but can also be used in other contexts. Before entering into any discussion or negotiation with another party, first, establish an anchor — an instant connection between your target and the offer you’re making. Once you have established this connection, any further discussion or negotiation will revolve around your offer rather than the other side’s.

For investors, An anchoring bias occurs when a person’s view of the price of a stock is anchored to an earlier time when prices were higher. It causes the investor to discount future losses while overlooking gains that might occur during that period. This can be detrimental when trying to time the market or identify technical indicators of imminent collapse.

Anchoring bias is a standard error in financial analysis and risk management. It occurs when traders and investors apply unrealistic standards and assumptions to measure risk and return on assets. This leads them to underweight some assets while overvaluing others, placing undue emphasis on short-term results and ignoring long-term trends.

Anchoring, like other valuation techniques, requires information about past performance to update future expectations. The fundamental approach is to consider both expected and actual performance and evaluate the degree to which they covary. Thus, expected future earnings are based on past performance, while actual future earnings are based on anticipated market conditions during the period under consideration.

In the classic example of anchoring, stocks with high expected returns are valued more than stocks with low expected returns. Investors who are willing to bet on high-return stocks are rewarded, and institutional investors are dissuaded from ignoring lower-return stocks when pricing their portfolios. Arbitrageurs seek out stocks with low prices to profit from the spread.

Anchoring yields two outcomes

1. Both assets and prices are valued in-line with the ability to earn future outputs;

 2. Prices are discounted relative to expected future earnings. While prices are anchored, earnings are free to deviate from today’s perceptions of value because earnings have not yet been estimated. 

This anchoring effect makes prices more flexible. Applying the concept of price elasticity to securities prices reveals that prices react more quickly to changes in market demand.