Are you influenced by the first piece of information you see?
Most people believe they think critically about decisions, carefully weighing out numerous possibilities before coming to a conclusion. Decades of research contradicts this belief, however—especially when it comes to the first thing you’re told about a topic.
This is known as the anchoring effect, a cognitive bias that greatly affects your financial decision-making.
First demonstrated by Daniel Kahneman and Amos Tversky in 1974—the first mention of anchoring was in 1958, but they were the first to research and test the hypothesis—the researchers discovered people use the first piece of information they see as an “anchor” to judge all subsequent information.
To test this idea, Kahneman and Tversky recruited students from the University of Oregon to spin a roulette wheel that was marked from 0 to 100. The caveat: the wheel was fixed so that it would stop on either 10 or 65. Each participant had to write their number down. They were then asked two questions:
- Is the percentage of African nations among UN members higher or smaller than the number you just wrote?
- What is your best guess of the percentage of African nations in the UN?
Participants who wrote down 10 averaged a guess of 25% for the second question. Those who landed on 65 landed on 45%. The higher roulette number influenced their decision-making.
As Kahneman writes in his classic book, Thinking, Fast and Slow,
People’s judgments were influenced by an obviously uninformative number. There was no way to describe the anchoring effect of a wheel of fortune as reasonable.
Humans are not reasonable animals. And that affects how we view and treat money.
Anchoring your finances
Spinning a wheel of fortune during a study is one thing. Behavioral economics is the study of (often irrational) decision-making in the real world. And yes, anchoring happens here as well—all the time.
Consider marketing efforts by traditional banks. They often list their interest rate in comparison with other banks, claiming their introductory 0.5% interest rate is five times higher than another bank, which is only offering 0.1%.
Five times higher sounds like a great deal—perhaps good enough for you to sign up. Mission achieved!
Let’s say that you later stumble upon a different financial service that’s offering 5% interest on your balance. Yet you’ve already anchored to the 0.5% rate. Given the fact that you’ve moved all your money over to the bank that initially caught your eye, you might not be willing to switch again. (This cognitive bias is known as inertia.)
You might even believe that the higher rate is too good to be true.
The anchoring effect helps to explain why large banks spend so much money on customer acquisition costs (CAC). If they can make their company seem ubiquitous, they build trust with potential customers. If they can afford all those billboards and magazine ads, they must be worth it! The bank has also planted a flag in order to cut out potential upstarts that try to invade its turf with higher rates.
Interest rates aren’t the only financial instrument subject to anchoring. The same phenomenon happens with credit cards rewards programs that offer you 100,000 points just for signing up. The number is so exceptionally high that potential users sometimes ignore the fine print—the fact that those points can be devalued at any time, for example.
And once you’re in their system, it’s hard to get out. Some anchors, it turns out, are heavy to lift.
Anchoring in action
Here’s the question we asked:
The Empire State Building is 1,454 feet tall. How tall is the Statue of Liberty?
- 305 feet
- 569 feet
- 834 feet
- 1,657 feet
The answers were varied, with most respondents choosing either 834 feet or 1,657 feet. Yet the Statue of Liberty is only 305 feet tall.
In this case, listing the height of the Empire State Building first unconsciously influences most people’s ability to estimate the height of the Statue of Liberty. This same phenomenon has been shown through research on real estate, car sales, salary negotiations, roulette, even Gandhi’s age when he died—another Kahneman/Tversky question.
Simply put, the first piece of information we see influences what we think about the next piece. If you're not paying attention, that can hurt your finances.
Cognitive biases are hard to overcome precisely because, as Kahneman and Tversky observed, they defy rationality. We can’t simply eradicate them. These biases are part of the evolutionary process of adapting to the changing circumstances in society.
Given the outsized role of financial psychology in our world, making better decisions around money can seem especially challenging.
While we can’t avoid these biases, we can overcome them.
The first step in overcoming any bias is recognizing that it exists. When you can slow down your judgments and think about what’s in your best interest, you’ve begun the process of overcoming anchoring.
Let’s return to the interest rate example. You notice a traditional bank offering 0.5% interest, is five times better than your current rate. You’ve anchored to that number.
Here’s the thing: you can move that anchor.
Find a better deal, then you just need to overcome inertia and make the right decision.
In technical terms, this means using controlled processing instead of automatic processing. Research has shown that holding people accountable with monetary incentives is an effective way to help them slow down their thinking and make better decisions. Instead of going with their instinctual choice, they take a few moments to mull it over, especially when the stakes are raised (no one likes to lose money).
In terms of anchoring to an interest rate, you just have to research other options. Is 0.5% really the best rate you can get for your savings account? Not at all. You’ll discover better options when comparing this rate with other financial services.
Then you can move the anchor.
Of course, this won’t work with every instance of anchoring. The height of a giant building is still going to influence your guess at the size of Lady Liberty.
Trivia is one thing. Your money is quite different. Slowing down and choosing wisely is in your best long-term interest.