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Behavorial Finance : Anchouring

Sadly most financial decisions are made based on irrational or insufficient analysis of data thus leading to irrationality.

Behavioral Finance combines behavioral and cognitive psychology theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.

 

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Our first lesson will be on the concept of Anchoring….An Anchor is any variable of information which has no direct relevance to a decision but does affect financial decision making. In essence a bit of information becomes “anchored” in our minds and thus automates our decision making.

An anchor can establish a low price to encourage a purchase decision or establish a higher price to lock in future purchases on that price. For example, a phone is list priced at N20,000 but the shop puts up a “10% Sale” sign beside the price, effectively “reducing the price to N18,000. The buyer however anchors in his mind that the phone costs N20,000 not N18,000, he assumes a N2000 “discount” and pays for it. If given a choice between this phone and a similar model costing 18,000, a buyer may select his phone believing a deal of N2,000 for a N20,000 phone.

Another excellent example is when a stock priced at N50.00 falls to N20.00.  An investor having anchored the previous N50 share price in his mind will determine that N20 is a “cheap” price and invest in that stock.

Key lessons on Anchoring

For the Purchaser: look at every investment on its merits not its antecedents. Past performance and prices are not a sufficient indication of future performance or prices. Do careful intrinsic evaluations before investing.

For the Entrepreneur: Be careful when setting prices. If your best pepper-soup for instance is  N2,000 per plate, that’s the anchor, customers will not pay above that prices for any other dish in your restaurant.

 

(Image: Pinkerton Wealth Management)

 

 

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