Anchoring Effect

Anchoring is a cognitive bias in decision making whereby the price perception of an individual is anchored on a piece of information (the anchor) previously offered. Anchoring effect is one of those terms that gets thrown around in business discussions, without perhaps being properly understood.

Kahneman and Tversky

The discovery of anchoring comes from a field called Behavioural Economics. The founding fathers of Behavioural Economics are two Israeli psychologists called Daniel Kahneman and Amos Tversky, who researched cognitive biases in decision making under uncertainty.

The first mention of anchoring in an academic paper was published in 1974 by Kahneman and Tversky. In experiments designed to study anchoring, participants are asked to perform a task (the anchor). This can be anything from spinning a wheel of fortune to writing down your age or telephone number. Subsequently, the participants are asked to answer a question on a given topic, for example, how old was Ghengis Kahn when he died? These studies have shown that people, in general, are affected by the anchors, even in cases where an anchor is a random number unrelated to the topic.

Does Anchoring Work?

Anchoring was being used in business even before academia coined the phrase. Walk into any car dealership and the first thing you will see is the most expensive model with the price prominently placed.

However, it must also be recognized that academic experiments on anchoring have two commonalities:

  • The participants have a short time to make a decision.
  • They make the decision by themselves.
  • They do not have expertise on the topic.

As a result, the participants are anchored by the reference point, in part, because of lack of other reference points. As a result, one should have reasonable reservations about the effectiveness of anchoring in the following scenarios:

  1. Negotiations with multiple stakeholders
  2. Purchasing decisions that have a long research phase
  3. When dealing with experts in their field

Examples of Anchoring

Despite the scenarios mentioned above, this author knows of an anecdotal case in which anchoring was applied in such a scenario. After the 2009 financial crises in Iceland, many real estate properties went into foreclosure.

During that time, a friend along with his business partner started looking into buying properties. At one point, the friend found an unusually small studio apartment in downtown Reykjavík and took an interest. After calling up the real estate agent, he found out that the property was actually under the ownership of the Central Bank of Iceland.

Realizing, that the market did not have properties to compare with this particular property, the partners sensed an opportunity. The day after, the business partner, met the real estate agent and inspected the house. He subsequently made an offer that was 40% lower than the asking price. The was refused. The next day, the friend went to see the apartment with the real estate agent and made a bid, 30% lower than the asking price. This time, the offer was accepted.

Why did this work? First of all, the person making the decision had very limited information. In all likelihood, had never been to the apartment. The decision maker also had limited time. This one apartment was probably one of a much larger portfolio that he was tasked with winding down. Thirdly, he had no clear reference point for the market price. When the business partner made his bid, it indicated to the seller that the state of the property was perhaps worse than expected. When the second bid came, it gave weight to that theory.