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Anchoring Bias Brings Other Dead Weight

Investors who are hindered by anchoring bias may also suffer from availability, outcome, and status quo bias.

Michael M. Pompian, 02/23/2012

This month's article is the fifth in a series called "Managing Behavior in a Volatile Market" and Part II of another important bias, anchoring. This series provides data and insight into the identification of key behavioral biases and also shows how to manage client behavior and emotion in this highly volatile market environment.

A substantial part of this series will be a review and analysis of answers to behavioral questions that were completed by a diverse set of 178 individual investors in 2011. The investors polled were not subscribers to Morningstar.com and/or Morningstar investor newsletter publications like the last survey, but they fit a similar profile in terms of investment objective and investor description.

By way of background, the survey questions were written to identify 20 key behavioral biases that I outline in my book, Behavioral Finance and Wealth Management. The second edition of the book, with updated biases and new case studies just hit the cyber-market.

As noted in earlier articles, the intent of the survey was twofold. First, I wanted to identify the most prevalent biases ("Primary Biases"), so advisors would know what to look for when working with their clients. Second, I wanted to identify what secondary behaviors ("Secondary Biases") might also be lurking behind these primary biases. In other words, if client Smith has easily recognizable bias X, what other of the 19 biases might client Smith also be subject to?

The purpose in doing this is that advisors can hopefully recognize not only primary biases, but secondary biases as well. Often it is the unrecognizable biases that can cause substantial harm when attempting to keep clients on track to attaining financial goals. Advisors can hopefully gain significant insight into a range of a client's behavioral tendencies simply by being aware of a single common bias.

In order to rank as a primary bias, 50% or more of respondents need to answer at least "Agree" or "Strongly Agree" to a question designed to identify a certain bias.

There were seven biases that garnered at least 50% positive responses:

Loss Aversion Bias: The pain of losses is greater than the pleasure of gains

Anchoring Bias: Getting "anchored" to a price point when making an investment decision

Hindsight Bias: Believing that investment outcomes should have been able to be predicted

Recency Bias: Taking investment action based on the most recent data or trend rather than putting current situations into historical perspective

Representativeness Bias: Making current investment decisions using the results of past similar investments as a frame of reference

Status Quo Bias: Not taking action to change one's investment portfolio (i.e., doing nothing when prompted to do so)

Regret: Past (poor) decisions affect future investment decisions

When you are providing advice to clients, at a minimum you should be looking out for these seven biases, as they are likely to be the most commonly encountered. For example, let's say you identify that a client is loss averse. What are the other irrational biases they might be subject to? This series is intended to help answer this question for the seven biases listed above and provide tips on overcoming them.

In this article we will review the biases associated with anchoring bias. Sixty-one percent of 178 people responded that they agreed or strongly agreed to a question asking them if they were subject to anchoring (i.e., when thinking about selling an investment, the price they paid is a big factor they consider before taking any action). Of that group, at least half were also subject to the following six biases:

1. Regret (65%)
2. Loss Aversion (63%)
3. Representativeness (61%)
4. Availability (54%)
5. Outcome (52%)
6. Status Quo (51%)

For example, of the respondents who said they were subject to anchoring, 65% of them were also subject to a question designed to identify regret bias, and so on for the other five biases.

In this article, I will provide commentary on the second three of these biases: availability, outcome and status quo. (Click here to see Part I of this article.) I will discuss why these biases are likely linked with anchoring and what one can do to counsel a client with these biases.

Anchoring and Availability
Anchoring and availability biases may not intuitively appear related, but I will try to explain the connection. In a strict sense, availability bias occurs when people use a heuristic approach (also known as a rule of thumb or a mental shortcut) to estimate the probability of an outcome based on how easily the outcome comes to mind. Recent events are much more easily remembered and available.

In the context of the survey, the meaning of availability was altered a bit to capture the likelihood that an action would be taken on information that was available and made sense to the person (after all, it's difficult to ask a survey taker if they use "available information"; of course they do!). So in this case, the question asked how quickly a person takes action on ideas that make sense to them (more quickly means they are more subject to availability bias).

In terms of anchoring, this behavior may indeed be linked to availability bias in that people use whatever information is available to them to justify becoming anchored to a price level. Everyone can justify to themselves what action to take if they are predisposed to take that action to begin with!

Advice: My advice to those investors subject to availability bias is to make sure they do their research or at least understand why an action is being taken. This way, if an investment goes down, they can assess whether or not they should continue with it. If not, poor investment outcomes may indeed be the result.

Anchoring and Outcome Bias
Once again, anchoring and outcome bias may not appear naturally tied, but when we dig into the details, we can see how they are connected. Outcome bias refers to the tendency of individuals to decide to do something, such as make an investment in a mutual fund, based on the outcome of past events (such as returns of the past five years) rather than by observing the process by which the outcome came about (the investment process used by the mutual fund manager over the past five years). An investor might think: "This manager had a fantastic five years. I am going to invest with her," rather than understanding how such great returns were generated or why the returns generated by other managers might not have had good results over the past five years.

As it relates to anchoring, what may indeed be going on is that investors who get anchored to a price level are focused on the outcome (i.e., making money or losing money), as opposed to the investment process they are using to make investment decisions.

Advice: The natural advice to those subject to outcome bias is to focus not so much on the outcome of an investment opportunity but the process by which the investment decision is being made. If one made money but did so in a way that did not follow a structured process, then this is luck. Conversely, if one does not make money but had a sound reason for making the investment--even though circumstances went against the investment--this is a better process and one that can be more reliable in the future. Luck is not an investment strategy!

Anchoring and Status Quo Bias
Anchoring and status quo are naturally tied. Some investors are more emotionally comfortable keeping things the same versus making a change, and thus they do not necessarily look for opportunities where change is beneficial. Given no apparent problem requiring a decision, the status quo is maintained. Further, if given a situation where one choice is the default choice (i.e., keep things the same), people will frequently let that choice stand rather than opting out of it and making another choice.

Advice: Getting investors who do not wish to take action to "get off the dime" and make some decisions is not easy. And demonstrating through quantitative analysis is not always effective. Similar to regret, what I often recommend is to take action in smaller increments. For example, if the task is to get invested, then clients can "average in" to the markets--taking three months or six months to get invested. This often puts the fear of losses aside; if an investment goes down, you can buy more at lower prices.

I hope you have learned something about anchoring and the biases connected with it. When you encounter a client with anchoring, consider the biases you have read about in this article. It might help to build a better client relationship! In next month's article, we will review the biases associated with hindsight bias.

Michael M. Pompian, CFA, CFP, is an investment consultant to ultra-affluent clients and family offices and is based in St. Louis. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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