Behavioral psychology and personal finance
This is the sixth article in our behavioral psychology series by Jonathan Walker, Co-Author of Anchors, Ostriches, and a HotPair of Scissors: Navigating Human Behavior as a Financial Professional. In this series Jonathan will help you understand how your brain deals with personal finances. Understanding these principles will help you manage your money and possibly avoid common but costly mistakes. Here is the full series:
- How to recruit your brain to help with better personal finances
- When being hot can hurt your personal finances
- How doing nothing can blow up your personal finances
- How to use mental accounting to improve your personal finances
- How too many choices can ruin your personal finances
- How anchoring can hurt your personal finances
- How an ostrich can destroy your personal finances
How anchoring can hurt your personal finances
Ever had a situation where a number doesn’t seem right? Maybe you thought it sounded high (or low) and so you started to doubt everything else about the situation. If your mind ever gets stuck on an expectation–especially if that expectation isn’t necessarily appropriate–you are feeling the effects of the behavioral psychology principle of anchoring.
What is the behavioral psychology idea of anchoring?
Anchoring, a principle in behavioral psychology, refers to the human tendency where someone relies heavily on an initial piece of information (the anchor) when making judgments or decisions.
Once an anchor is established, judgments and evaluations can be biased towards the anchor. Here’s the weir part: we can be biased by an anchor even if it is arbitrary or irrelevant to the decision at hand.
How can the behavioral psychology principle of anchoring affect my personal finances?
Everyone gets anchored, no matter how much we might think we are too smart to be so irrational. It’s part of being human. The problem is that it can be really tough to see when your expectations are legitimate and when they are the biases of anchoring keeping you from seeing the situation more clearly.
Sometimes, our minds can just get stuck.
Anchoring can significantly influence financial decisions, as it can sway our perceptions of value, pricing, or negotiation outcomes. Being aware of anchoring bias can help us be more critical as we evaluate information. Recognizing how anchoring works can also encourage us to consider a broader range of factors when we have to make a judgment.
We have the power to make more objective and rational judgments, but it does take effort.
What ways can anchoring affect your personal finances?
The behavioral psychology principle of anchoring can affect your personal finances in several ways:
Anchoring can influence your perception of prices. When presented with an initial price, such as a listed price or market value, it becomes an anchor point that influences your judgment of whether a price is fair, expensive, or a good deal. Anchoring bias can make you more likely to accept higher prices if they are presented after a high anchor or perceive lower prices as bargains even if they are still relatively high.
Anchoring bias can impact your decision-making process. The initial anchor can affect how you might view options that come after it. For example, when considering investment options, you may anchor your expectations based on past returns or the initial purchase price. This can lead to biased decisions, such as holding onto underperforming investments or being hesitant to sell even when you should.
Anchoring can influence negotiation outcomes, such as salary negotiations or bargaining for lower prices. The first number mentioned or proposed in a negotiation becomes the anchor that can affect how the rest of the negotiation goes. For instance, if a recruiter sets an initial salary expectation unacceptably low, you might feel like you made significant progress getting a higher salary even if you are still below the industry average.
Anchoring can affect your financial planning and goals. If you decided how much you need to save for retirement when you were younger, you could be anchored to a number that is too low for the way you want to retire as you get closer to that date. If you set an expectation of when you will be debt free, you might not be as aggressive as you could be to pay down the principle when you have the chance.
Be cautious about financial targets or expectations, such as retirement savings or debt repayment goals. Those anchors can influence your planning and strategies. Deviations from these anchors may lead to emotional reactions, dissatisfaction, or a reluctance to adjust plans as needed.
Anchoring bias can impact how you see the value of products, services, or investments. If you encounter a high-priced item first, other options may seem cheaper and more attractive in comparison, even if they are not the best choice you could make. This can lead you to make decisions based on comparison rather than considering the overall quality or suitability for your financial goals.
Awareness of anchoring bias is essential to minimize its negative impact on your personal finances.
What are examples of anchoring in personal finance
Three examples of the anchoring principle in personal finance are:
- Pricing perceptions: If a product is initially presented at a higher price, you might see later lower prices as a better deal even if the price is still relatively high compared to the actual value. Anchoring on the initial higher price can influence purchasing decisions and lead individuals to make purchases they might otherwise consider too expensive.
- Salary negotiations: When negotiating a salary, the first number mentioned or suggested by either party can serve as an anchor that influences the final negotiated salary. If the initial anchor is set at a higher level, it can lead to higher salary offers or counteroffers compared to situations where the anchor is set lower. Anchoring bias can impact both employees and employers during salary discussions.
- Investment decisions: If you purchase a stock at a high price, you might anchor you expectation for future returns based on that high price. Even if the stock’s value declines significantly, you may still hold onto it, hoping it will return to the initial high price. This anchoring bias can lead to holding onto underperforming investments for longer than warranted.
How to keep anchoring from disrupting your personal finances
Anchoring can be particularly challenging because you are unlikely to know when it is happening to you. So, if anchoring is invisible, how could we possibly make sure that it doesn’t hurt our personal finances?
The key is to create habits around how you make decisions and judge alternatives. To prevent the disruptive effects of anchoring on personal finances, you can employ several strategies:
Seek multiple perspectives
Gather information from various sources to gain a broader understanding of the situation. By considering different viewpoints, you can prevent anchoring bias from solely relying on one initial piece of information. Consult trusted advisors, conduct research, and seek alternative opinions to challenge and balance the anchoring effect.
Establish your own reference point
Do enough research to help you establish your own reference points. By evaluating multiple data points and sources, you can avoid relying solely on the initial anchor. Compare prices, investigate market trends, and critically assess the value of products, services, or investment opportunities.
Establish decision criteria
Determine upfront how you will be making a decision before you are exposed to an anchor. By setting clear benchmarks or standards for judgment, you can ensure that your decisions are based on objective factors rather than being swayed by arbitrary anchors. For example, determine a budget range before shopping for a specific item to avoid being unduly influenced by the initial price tag.
Actively seek out alternative options and evaluate them independently. By expanding your choices, you can counteract the anchoring bias. This can involve exploring different product options, seeking multiple job offers or salary references, or diversifying your investment portfolio. By comparing alternatives, you are less likely to be fixated on a single anchor point.
Take the time to think
Avoid making hasty decisions by taking time to think without the pressure imposed by the situation. Anchoring bias tends to be stronger when decisions are made quickly, without sufficient thought or consideration of alternatives. Give yourself space to step back, gather information, and critically evaluate the options before making a final decision.
Actively question yourself
Honestly consider how you might be affected by a reference point. You can consciously challenge and adjust your decision-making process to make sure you don’t fall to habits or lazy thinking. Actively question and reassess the influence of anchors in your financial choices.
By implementing these strategies, individuals can reduce the impact of anchoring bias on their personal finances and make more informed, rational decisions based on a broader range of factors.