The fact investors can be swayed toward or away from an optimally diversified portfolio has the potential to affect their risk exposure.pixel_dreams/iStockPhoto / Getty Images
Suppose an investor has an important financial decision to make. As she is about to decide, her financial advisor casually drops an irrelevant number into the conversation. Might that number influence the outcome of the investor’s deliberation? Of course, it shouldn’t. And yet, it likely will – with the potential for unintended consequences.
Psychologists Amos Tversky and Daniel Kahneman were the first to identify this cognitive bias, which they labelled anchoring, in a paper they published in 1974. Specifically, they showed that a person’s quantitative judgments and decisions can be pulled closer to a specific number she might observe immediately prior to deciding, even if that number is generated randomly.
The psychologists demonstrated the anchoring effect by asking people to estimate the percentage of countries in the United Nations that were in Africa, but only after first having each person spin a wheel that generated a number between 0 and 100. The people who spun relatively high numbers on the wheel tended to estimate higher percentages of countries in Africa that were in the U.N. than those people who spun lower numbers.
Anchoring has also been demonstrated in settings involving money, including an example Duke University researcher Dan Ariely included in his book Predictably Irrational. In an experiment, people were instructed to write down the last two digits of their social security number immediately prior to reporting how much they would pay for a bottle of wine. It turned out those who wrote down higher digits were willing to pay higher prices even though the number, which served as an anchor, was uninformative about the value of the wine.
So, how might anchoring matter in the context of investment decisions? To explore that question, I ran a simple experiment involving 200 people who had some degree of previous experience with investing. For half of the participants, I asked whether a well-diversified portfolio should contain more than or fewer than five stocks. For the other half, I replaced five with 15. The question wasn’t prescriptive; its only purpose was to plant a reference point or anchor in the minds of the deciders.
When the participants were then asked how many stocks they would put in their portfolios if they were redesigning it to be well diversified, the effects of anchoring became evident. The high-anchor group chose an average of 23 stocks whereas the average response for the low-anchor group was 10.
Most research in finance suggests investors ought to hold at least 30 individual stocks spread across various sectors – and ideally across different countries – to minimize diversifiable risk adequately. Thus, the fact people can be swayed toward or away from an optimally diversified portfolio has the potential to affect their risk exposure.
An entrepreneurial advisor might consider implementing a version of this experiment with a client as a means to starting a dialogue about diversification. (The fuller conversation would naturally include talking points on foreign investment, products other than stocks and additional factors that contribute to diversification.)
There are additional situations in which advisors can use anchors to steer their clients to better decision outcomes. For example, an anchor can be used to encourage a client to save a higher percentage of her take-home pay. If the client is currently socking away only 5 per cent of it, the advisor could spark a conversation by asking whether 25 per cent might be a more appropriate target, followed up by a careful evaluation of what saving rate is feasible based on the client’s own specific circumstances. Even if 25 per cent is too ambitious, the client’s thoughts will have been tethered to the specified anchor, perhaps leading to a higher rate of saving than if no anchor were provided at all.
Self-aware advisors will notice that they’re just as prone to the possible influence of anchors as their clients. Accordingly, advisors ought to be aware that quantities such as a client’s pre-existing savings rate or proportion of investment allocated to stocks versus bonds might serve as inadvertent anchors by which subsequent recommendations may be influenced unintentionally.
Awareness of human nature is the first step to managing the unplanned effects of anchoring. The next logical step is to be prepared to override extraneous numbers by seeking to make decisions guided by objective information obtained through diligent research rather than making impulsive decisions, which are more likely to be affected adversely by biases such as anchoring.
Lisa Kramer is professor of finance at the University of Toronto, where she conducts research and teaches on the topic of behavioural finance. You can follow her on Twitter: @LisaKramer.