This post is one in a series where we continue to explore how behavioral biases can affect merger decisions. Joe started this discussion over a year and a half ago in a post entitled, Behavioral Bias, the Hidden Risk in Mergers and Acquisitions. For years, economists have assumed that men and women were rational in their decision making and that markets were efficient. To quickly come to the defense of economists (because on my better days I resemble one), these assumptions are not necessarily in place because we thought they were true. Rather, they present a meaningful standard for testing alternate hypotheses. After all, I can explain virtually anything but just telling you the decision maker was irrational. So too can I explain any movements in the stock market by simply throwing up my hands and declaring markets are inefficient. There is not much value in those two statements.
There is value in carefully documenting empirical regularities in decision making. The advancements in the field of behavioral finance have occurred simultaneously with two phenomena: 1) the growth of experimental economics where subjects are presented alternate choices in a controlled setting and researchers are able to carefully measure and calibrate the tests and 2) an increased appreciation in the field of finance for the psychological sciences.
The literature on behavioral biases has been voluminous in recent years and we can only hope to start the dialogue and acknowledge some of the issues in these short posts. Today, I just want to talk a bit about one of these biases: anchoring.
The anchoring effect occurs when we give too much weight to some value presented early in the decision making process. Research shows that final values are influenced by this initial number, even if it is irrelevant. An interesting article in by Edward Teach in (see CFO magazine, Avoiding Decision Traps) gives many excellent examples. In one, researcher Dan Aerily asked his MBA students to write down the last two digits of their social security number. Subsequent to this, they bid on bottles of wine and boxes of chocolate. Students whose SS numbers were higher placed bids that were 60 to 120 percent higher. Obviously, one's SS number has no relation to the actual value of the item, yet it had a major influence in the bidding.
In many cases the anchoring number is presented to us as with the list value of a car, or the stated value of an item at a department store. When we purchased the item at a lower price we feel that we obtained a bargain. In fact, the initial number may have been grossly overstated or irrelevant. Similarly, when a bidding or target firm suggests an initial value an anchor is created, one that often influences the outcome.
The price at which we purchased a stock can create an anchor even though (except for tax purposes) that value is irrelevant today. I don't feel good about the Apple stock I purchased at $700 and I might be irrationally reluctant to sell below that price even if the true value is less.
Other times, investors will anchor at the recent 52 week high value of a stock or its book value even though these numbers can bear little resemblance to true value.
The lesson is to be aware and wary of the anchoring phenomena and where possible estimate values on your own without initial regard to other estimates.
We will continue with other observations.
All the best,
Ralph
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