Prospect Theory shows us that we measure gains and losses relative to a set reference point or status quo (see my previous article). This particular reference point is subjective and can be different for different people in different scenarios.
In 1974, Amos Tversky and Daniel Kahneman performed an experiment where they asked participants: “What is the percentage of African nations in the UN?” while spinning a wheel of fortune with numbers from 1 to 100 on it. Even though where the wheel stopped was completely irrelevant, it was found that it did influence the answers given by the participants. They were asked whether their answer was higher or lower than the number shown on the wheel of fortune. Results showed that, according to the participants, the percentage of African countries in the UN was 25 per cent for the group that witnessed the wheel of fortune stopping on the number 10 and 45 per cent for the group that witnessed it stopping on the number 65.
How can a completely irrelevant number affect our decision-making?
Consider a simple purchase transaction. You see an item and think it’s worth R1 000. If you’re able to purchase it for less than that = bargain; if not = not such a bargain. Now consider the same transaction but this time there is an asking price of R800. This is your new reference point. You’ve been anchored to the R800. If you’re able to purchase the item for R900, you’d feel hard done by even though, in the first scenario, you would have considered this to be a bargain.
The term ‘anchoring’ is suitably named. Anchors of ships are put into the ocean to ensure they don’t stray too far away from a certain point. We do the same with our reference points.
Whether you’re speaking to a real-estate agent, car salesman, or walking down the aisle at your local supermarket, beware of being anchored to a reference point. “Buy 4 for the price of 3!” That’s anchoring right there.
We’ve already learnt that human beings are loss-averse. We’ll do anything to avoid a loss. As a result of this, decisions are often framed in such a way that the potential losses are highlighted to us (think of insurance) and this creates an anchor pushing us to choose the option that avoids such losses.
When you speak to your financial advisor, their recommendations are anchors. And how does a company’s earnings announcement affect your assessment of their stock price?
Anchoring is prevalent in everyday decision-making. What we should be mindful of is the need to differentiate between price and value. Forget about the ‘deal’ or what’s being punted. Make decisions based on the intrinsic value of the transaction. ❐
Author: Gizelle Willows CA(SA)