24 March 2020 | HYCM – When you look into how cognitive biases work and just how many of them there are, you quickly start to question your own ability to make rational choices. As a trader, this questioning can be an enormously valuable practice. The fact that we’re not as rational as we may believe was demonstrated to devastating effect in the seminal work of Daniel Kahneman and Amos Tversky on Prospect Theory in the late 1970s. Their work led to the development of Behavioural Economics, an entirely new field of study that has gone on to challenge many of the most dearly-held assumptions of classical economics.
Anchoring is a particularly ingrained cognitive bias. Not only can it be reliably tested under experimental conditions, but it can also be measured. To quote Kahneman himself, anchoring “…occurs when people consider a particular value for an unknown quantity before estimating that quantity. What happens is one of the most reliable and robust results of experimental psychology: the estimates stay close to the number that people considered…”
In the famous experiment conducted by the pair, students were asked to spin a wheel of fortune that had been rigged to either stop on 10 or 65. They were asked whether the percentage of African nations that were UN members was larger or smaller than the number they had spun, and were then asked to guess the percentage. The average estimates of those who spun a 10 on the wheel were 25%. The average for those who spun 65 was 45%. This anchoring effect has been confirmed in many different experiments both in and out of the laboratory. Whether its judges deciding on greater or smaller sentences, rolling higher or lower numbers on a die, or estate agents overvaluing properties when being provided with inflated asking prices.
How it’s used in sales
Those among you with a background in sales will already be familiar with this bias and have probably used it to your benefit at some point in the past. Anchoring works regardless of the domain. We unconsciously anchor our expectations to a value that we encounter when trying to make a decision about a value that we’re undecided on. It’s why negotiations usually begin with a high number if you’re selling, or a “low ball” figure if you’re buying. It’s to anchor expectations at a value that serves your interests in the hope of pulling the final price closer to it.
Say you’re roaming around your local shopping centre and you stumble upon a pair of designer boots that you just saw your favourite celebrity sporting the other day. The manner in which you first encounter their price will almost certainly influence what you choose to do next.
For example, in scenario 1 you enter the store and gingerly turn the label over, it says $600. Knowing what you know about the margin on luxury items, you can suppose that the cost of the material and labour that went into them is well below this price. But on the other hand, you know that the company makes good products that last a long time and you’re also not immune to the prestige that wearing such a brand confers on you. At this point, you may decide that $600 is too much right now and resolve to keep checking back, just in case the price drops at a later date.
In scenario 2 you carefully flip that label over and see that the price is $600 after having been discounted from $1000. All the same, things that would have gone through your mind in scenario 1 still hold true for scenario 2, however, this time your anchor has been set $400 higher at $1000. At $600 dollars, the designer boots now seem like a great deal. To say nothing of the fact that every minute you delay gives someone else a chance to come in and buy the last pair they have in your size.
How anchoring manifests in trading
Nearly all traders, whether institutional or retail, experienced or beginner, have been shown to anchor at the price that they first bought an asset. This takes place across all asset classes, whether it’s FX, stocks, commodities or indeed anything with a moving price. All future prices are then judged as being cheap or expensive in relation to the price at that initial encounter.
This, as you might imagine, is completely irrational behaviour and yet we all seem to be prone to it. It completely flies in the face of classical economic theory, which would have us believe that we’re all rational economic actors, who evaluate new incoming data when it arises and make choices that maximise our utility at any given moment.
In practice, price anchoring works as follows. You buy gold at $1500. In the following days it rises slightly in price, going up to $1530. A week later it sinks to $1450 and you begin to worry. Another week passes and it drops even further to $1425. You become distraught and start to panic. It was rash of you to buy at the top end of the range. You pray that it goes back up and plan to immediately close your position as soon as the price approaches $1500 again. Two weeks later you close out your position at an average price of $1498. The following month, after having established $1450 as support, gold continues on its upward path to $1700 and you feel absolutely terrible.
What happened here? That $1500 price point at which you initially bought gold became the most significant figure in your thinking. In reality, it was the least significant. The hypothetical trade above took place over the course of more than two months. In that time a million different things could have occurred in the world to cause the price to move as it did. What were you focused on? The price at which you got in. What does the market care the least about? That’s right, the price at which you got in.
This doesn’t just hold true in the short-term during individual trades. It also has an effect on your long-term relationship with asset prices. Say you were trading gold back in 2008, in the wake of the Great Financial Crisis. You were fortunate, or prudent, enough to have cash on reserve, allowing you to make investments when others were scrambling around to cover their margin calls. You initially bought gold at $800 and rode it all the way up to $1600. It was your first gold trade and it went extremely well for you. You sold your position at $1600, not wanting to be greedy and not knowing whether the rally would continue. You didn’t sell at the very top but you did well, better than many other traders around you.
Now let’s fast-forward to 2016 when gold bottomed-out following its all-time highs at around $1900 in 2011. Again, you find yourself on the sidelines watching the price. You’ve done your macroeconomic research and have concluded that gold will be a good investment for the following few years. You have cash on reserve and are ready to invest.
However, on this occasion, there’s a previous history with gold influencing your decisions. Back in 2008, you bought at $800 when you could actually have gotten in as low as $680 if you had been more aggressive. So now, as the price of gold touches $1050, even though your research is telling you to buy, you don’t. Why? Because the price you got in at eight years ago is influencing your decisions today. $1050 will prove to be the low for 2016, but you don’t know this and so you hold off on buying, hoping that the price will drop even further. You miss the move and have to sit back and watch as the price climbs out of reach.
The following year it drops back down to around $1100 but you end up missing this move too, expecting to be able to buy closer to $800. Then, in August of 2018, gold’s price drops once more to around $1160. You still don’t buy, convinced that it’s bound to drop closer to a price that you recognize as being “cheap.” The rest is history.
What went wrong? To the exclusion of all data to the contrary, you overestimated the relevance of that $800 price that you initially bought at. The moral of the story? The market doesn’t care about the prices that you buy or sell at, only you do. Cheap and expensive are completely relative terms. As an investor, it’s incredibly important to at least recognize this bias. Preventing it from happening altogether is a much harder process but understanding that it exists can help to put many of your decisions into context. So, next time you’re about to open a position, close one or forego doing so, ask yourself: “does this price level mean more to me than to anyone else?”
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