Here's How Our Brains Are Tricked into Spending Too Much Money
Overcoming the "Anchoring Effect"
“Price is what you pay; value is what you get.”
-Warren Buffett
Welcome to another installment in my ongoing series called “Money On My Mind,” where I publish articles to help you deal with the psychological aspects of managing money. Check out past editions of the series here.
We continue our exploration of cognitive biases by looking at the anchoring bias, which is a leading cause of poor financial decisions.
Continue reading to learn:
What anchoring bias is
How it causes you to overspend
The impact it has on salary negotiations
How it can lead to poor investing decisions
What is anchoring bias?
Anchoring is when we rely too heavily on either a pre-existing piece of information or the first piece of information presented to us.
This image perfectly explains how anchoring bias leads to overpaying.
You walk into a department store, and you see two identical-looking black T-Shirts; one listed at $500 and one “on sale,” marked down from $800 to $500. “You walk over to the shirt on sale and think, wow, I can get this shirt for $300 off.” You should think, “wow, why would anyone spend $500 on a single shirt.”
This is an extreme example, but it highlights how anchoring works. If the first thing you notice is that the “original” price of the shirt was $800, then paying $500 can seem like a deal. Your mind is “anchored” to the original price of $800, so anything less than that seems like a pretty good deal.
Most people love to feel like they are getting a deal. Businesses are not stupid; they understand this. Anchoring is the reason it’s so common to walk into a big box store and see nearly every item “marked down.” It’s also why people are willing to fight and climb over a pile of other consumers during a Black Friday to save $300 on a flatscreen T.V.
Why we are so vulnerable to anchoring bias
The seminal research paper on the anchoring effect was a 1974 paper written by Amos Tversky and Daniel Kahneman.1 Tversky and Kahneman described anchoring as the tendency to make an estimate starting from an initial value.
To quote the paper:
“Different starting points yield different estimates, which are biased toward the initial values. We call this phenomenon anchoring.”
In the example I gave about the overpriced t-shirt that looked “like a deal” because it was on sale, the original price of the shirt was the anchor, which influences the perception of value for the sale price.
That example undersells the power of anchoring. As Tversky and Kahneman point out, even completely random numbers unrelated to the decision at hand can influence your perceptions.
Tversky and Kahneman describe an experiment where participants in a study were tasked with spinning a “wheel of fortune” style spinner with numbers ranging from 0-100. After spinning the wheel, people were asked to guess the percentage of African countries represented in the United Nations.
What they found was that the number they spun at random was directly correlated to their guess about the percentage of African countries in the U.N. Those who spun a 10 on the wheel guessed 25% of African countries were in the U.N. and those who spun a 65 guessed 45% on average.
Having a random—but relatively high— number in your head before estimating percentages is enough to nudge the human brain into guessing a high number and vice-versa. That’s how simple it is to influence human decision-making.
Anchoring can impact just about every kind of decision you can think of. From something as trivial as guessing how many African countries are represented in the U.N. to life-changing decisions like the length of a prison sentence handed down by a judge.
A 2006 study found that the sentence requested by prosecutors directly impacted the actual sentence handed down by a judge.2 The more years demanded by a prosecutor, the more years the judge will likely hand out and vice versa. The research also found that the framing effect on sentencing was independent of the relevance of the prosecution's requests and the experience of the judge. If you're going to be found guilty of a crime, the best thing you can hope for is a prosecutor who does not ask for the maximum sentence.