The Hindu Business Line : A mental shortcut

It is easier for the dealer to sell the car if he later brings down the price from, say, Rs 1.5 lakh to Rs 1.25 lakh. As a consumer, you will typically relate the final price to the one that was quoted first. And chances are you may pride yourself for bargaining with the dealer. Your decision-making is "anchored" to the price quoted first.

Some portfolio managers take advantage of "anchoring" to buy/sell stocks. Suppose a company recorded 20 per cent earnings growth last quarter. We may expect a similar growth rate this quarter as well.

But what if the company actually reports a 40 per cent growth in earnings? We may initially brush aside this growth rate as temporary, based on our "anchor" rate of 20 per cent.

In other words, we under-react to the information. This provides smart portfolio managers a chance to buy the stock cheap before the market realises the under-reaction.

Anchoring is essentially a mental shortcut (or heuristic) we adopt for taking decisions. Kahnemann and Tversky first recorded this effect in 1974.

It is perhaps also the reason we have "support" and "resistance" levels for stocks. Suppose you buy Infosys at Rs 2,500, and the stock thereafter moves to Rs 2,800 but immediately declines to Rs 2,550. The next time the stock moves to Rs 2,800, you and I are likely to sell our holding. The reason is that we are "anchored" to the previous stock behaviour.

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