Raskin Planning Group

Making Irrational Financial Decisions is Only Human (Part 1): Anchoring

{5:50 minutes to read}

Classic economic and investment theory suggests that people act rationally. However, research by psychologists and social scientists in the mid-1990’s has shown that people often make irrational decisions in specific and predictable ways.

Our next few articles will discuss how behavioral economics and behavioral finance affects decision-making. Understanding behavioral science won’t turn you into a robot consistently making the most profitable, well-reasoned and rational financial decisions. Hopefully, these articles will help you understand and improve your financial decision-making.

Are all of your financial decisions based on rational and relevant facts? In many instances, the answer is probably yes. However, humans have a tendency to attach or “anchor” beliefs to a reference point, even though the reference point has very little to do with the actual decision under consideration. These anchors can lead us to make financial decisions that aren’t in our best interests and don’t help us meet our personal financial objectives. Here are some examples of anchoring:

Example 1: Most of us aren’t wine experts and we will enjoy a $35 bottle of wine almost as much as a $70 bottle of wine. The wine list at your favorite restaurant probably offers a long list of wines, with bottles costing $35 to $500 (or higher). Most wines on the menu will cost between $40 and $100 and those are the bottles most frequently sold. When patrons look at the wine list, they see the very high priced bottles and those prices become the “anchor” from a cost perspective. The $50 or $75 bottle is now considered a “bargain” price compared to the $100 bottle of wine. The anchor price of $100 is really irrelevant to the decision since most customers don’t really appreciate the value of spending more on wine. Rationally, most people would be just as happy drinking a $35 bottle of wine and saving the difference for another night out.

Example 2: The jewelry industry would have you believe that a diamond engagement ring should cost around two months’ worth of salary. It may be a jewelry industry accepted standard, but it is totally illogical and has nothing to do with the decision about how much to spend on jewelry. Nevertheless, if a salesperson tells a buyer about this supposed standard, it may become the price anchor and the buyer may decide to spend more on a ring than they should afford.

Example 3: Anchoring on a perceived value may affect your objective to sell your home and purchase a larger, more expensive one.

  • Let’s say you purchased your residence in 1995 for $500,000.
  • Ten years later, your neighbor sold a nearly identical home for $1,000,000.
  • In 2007, the great recession started and housing values plummeted by 20% or more.
  • In 2009, you wanted to sell your home, but a realtor recommends you put it on the market for $800,000.

You decide to wait until the housing market rebounds and your house appreciates back to $1,000,000, your reference point as to the market value of your home.

In fact, your home is worth $1,000,000 only if someone is willing to pay $1,000,000 for it. The market value of the home in 2005 has nothing to do with the actual value in 2009. The realtor looked at comparable homes and provided a reasonable current market valuation in 2009. The market price in 2005 just isn’t relevant to the market price in 2009.

It could have been in your best interest to sell the home at 20% less than your anchored value of $1,000,000, assuming the new house was also discounted by a similar or greater amount, a likely scenario.

Example 4: You have been following a company for about a year and believe their products and marketing campaigns are fantastic. The stock has increased from $75 to $100 per share in only 12 months.

Since the stock is at an all-time high, you decide not to buy it because the share price seems high. Soon thereafter, the company releases a new product and it doesn’t meet sales expectations. Consequently, the stock drops 10% over a two-week period. You see this as a great buying opportunity, thinking the recent sales disappointment and the drop in value are temporary and will rebound to its previous high. It seems like the stock is a pretty good bargain.

Over the next 12 months, the stock continues to languish, dropping to $75 per share. At the same time, the S&P 500 has increased in value.

This is a great example of an investor anchoring on a price of $100, but ignoring longer term trends and other important facts. This stock has actually been a highly volatile stock over the last 10 years, bouncing between $50 and $100. At $90 per share, the stock wasn’t such a great bargain. With a bit more research and patience, the investor should have waited to purchase the stock at a real bargain price of $50 or $60 per share.

As wealth managers and financial planners, the Raskin Planning Group believes that rational and thoughtful economic decisions will give you the best chance of meeting your objectives.

Anchoring sometimes will cause us to make decisions that are less than ideal. Our role is to be your guide, presenting facts and asking questions. Our financial planning perspective will help you avoid common human mistakes. Please don’t hesitate to call us with your questions.

Peter Raskin is a registered representative of Lincoln Financial Advisors Corp. Securities offered through Lincoln Financial Advisors Corp., a broker-dealer (SIPC). Investment advisory services offered through Sagemark Consulting, a division of Lincoln Financial Advisors Corp., a registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. 125 Summer Street, Suite 1400, Boston, MA 02110 617.728.7444. Raskin Planning Group is not an affiliate of Lincoln Financial Advisors. CRN-1264411-080315