Anchoring in Behavioral Finance

What is Behavioural Finance?

Behavioural finance is a field of behavioural economics that deals with investors’ psychological influences and biases. It studies how these influences and biases affect the financial behaviour that investors use in investing decisions. Similarly, behavioural finance also explores market anomalies, specifically in the stock market. It looks at how influences and biases can cause these anomalies to exist.

Behavioural finance opposes any traditional finance theories in various regards. For example, some traditional theories assume that investors do not allow biases or influences to affect their decisions. However, behavioural finance tackles that by suggesting that investors make decisions under the influence of biases.

There are several concepts in behavioural finance that explain how investors behave in the stock market. One of these includes anchoring, which can further lead to anchoring bias. Before understanding what anchoring bias is, it is crucial to understand the concept of anchoring in behavioural finance.

What is Anchoring in Behavioural Finance?

Anchoring refers to attaching a spending level to a certain reference. It is when investors put too much reliance on historical information or the first information they find. Usually, this information is irrelevant. Since investors find this information to existing beforehand, they put more reliance on it than they should. Overall, anchoring is the use of irrelevant information for decision-making.

Anchoring gives rise to anchoring bias, which can lead to incorrect financial decisions. For example, when an investor holds to a stock, despite making losses. It is because they stick to their original estimates for profitability. This way, they are oblivious to any relevant data that may exist.

Anchoring occurs when investors make estimates about various stocks. Since they start the process with an initial value and make adjustments to it, they are likely to stick to their initial value. This process of sticking or holding to the initial decisions or estimates is known as anchoring.

Overall, anchoring can lead to incorrect decisions because of initial perception. Investors generally ignore this bias if they isolate the decision. However, since they look at everything from an initially biased perspective, they are likely to make the wrong decision.

What is Anchoring Bias?

Anchoring bias is a bias that stems from the concept of anchoring. Anchoring bias is when investors make incorrect financial decisions by basing these decisions on one point of information. Based on this starting point, investors tend to form an initial opinion. During any subsequent transactions, investors let the bias influence their decisions based on that opinion.

Anchoring bias exists in all markets and for all investors. Usually, it is prevalent in decision-making areas where investors need to make estimates or use historical information. Although this information may not be irrelevant anymore, investors tend to favour it when making decisions. According to behavioural finance, anchoring bias can cause investors to reject rational choices.

Anchoring bias can cause many problems for investors in financial markets. This bias can lead investors to look at past investment performance for a product and assume the same trend will continue in the future. Similarly, it can cause investors to delay their investment decisions, such as selling an investment. Anchoring bias can make investors biased toward new information. Through all of these, investors can make incorrect decisions and suffer losses.

Conclusion

Behavioural finance is an area of behavioural economics that deals with how investors allow psychological influences and biases to affect their decisions. Anchoring is a concept in behavioural finance that relates to when investors put overreliance on irrelevant information. Anchoring bias is the bias that comes from anchoring.

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