Even before being an entrepreneur, I’ve always been a fan of the Shark Tank show. In each episode, a handful of business owners present their ideas to the Sharks, a panel of successful entrepreneurs like Mark Cuban and Daymond John, and ask them for capital in exchange for partial ownership of their business. I love learning how people come up with ideas and how they make their businesses work, sometimes through a lot of adversity. And I have to admit, it’s just fun watching the Sharks negotiate a deal.
You may have heard, as I have, that if you are part of a negotiation, you should never be the first to make an offer. The conventional wisdom is that if you make the first offer, it could be lower than what the other party is willing to pay, and you could end up taking less than if you had let them enter their number first. But is that true?
Three academics from Duke, the University of Michigan and the University of Houston recently set out to determine whether making the first offer was beneficial or detrimental in a negotiation. Their study found that while the people who made the first offer had increased anxiety, they also finished financially better. Being the first to propose terms helped them get the most out of the deal.
While this information may be helpful to you the next time you walk into a car dealership or job interview, the concept behind how to negotiate is much broader than that. Fundamentally, the question of how best to trade is how best to take advantage of the anchor effect. The anchoring effect is a cognitive bias, or automatic error in thinking, to which our brain is susceptible, and we can observe it in almost any environment that requires decision-making.
When we are presented with a choice to make, we will base our decision largely on the first information we obtain, so that the result is skewed by the information that is presented first.
In the case of a negotiation, making the first offer can be an advantage for us because we decide what the first data presented will be. For example, when requesting a raise of $ 10,000 we establish the point around which the rest of the negotiation will be based. Consider the difference between how we (and our employer) might feel about a $ 7,500 raise if we asked for $ 10,000 and a $ 7,500 raise if we asked for $ 5,000. One will seem like a win and the other a defeat, all based on the number we anchor ourselves to from the start.
The anchoring effect also affects our purchasing decisions. If the car you want costs $ 25,000 but sits next to another car on the lot that is selling for $ 45,000, it likely appears to be more reasonably priced. On the contrary, if you were next to a car that is selling for $ 15,000, it could look expensive. The price tag never changes, but the way we feel about it, and therefore the decision we make about it, changes based on the cost relative to the anchor.
There are endless ways in which the anchoring effect manifests itself in our financial lives. We may refuse to sell an investment because we are anchored to the price we pay for it, regardless of whether the investment is still appropriate for our portfolio. We could list our house based on the sale price of the house down the street, regardless of whether the properties are of comparable value. We could insist on having a certain amount of money before we retire and continue working even if it is not necessary.
The anchor effect can also affect what we do during stock market turmoil. During periods like the one we are living in now, in which investment portfolios and house prices have continued to rise, it is natural to look at how much we are worth on paper and anchor ourselves to that new higher number. From that point on, if the values of our assets decrease, it is likely that we will see it as a loss. If values decline dramatically, this perceived loss can be especially painful and lead us to believe that there is something wrong with our investment strategy.
Consider how you would feel if your net worth recently exceeded $ 1,000,000. Now consider how you would feel if in a few months that number dropped to $ 750,000. Did the words disappointed, confused, or scared come to mind? Now consider whether it was anchored to your net worth two years ago, when it was worth $ 700,000. Suddenly $ 750,000 doesn’t feel too bad. You may not be completely satisfied with a gain of $ 50,000, but it would feel significantly different than a perceived loss of $ 250,000.
The difference between anchoring these two numbers, $ 1 million versus $ 700,000, isn’t just about putting a lighthearted spin on volatile markets. It’s about helping us manage the negative emotions that occur when markets go through their inevitable periods of decline. If we continually anchor ourselves to our higher net worth, we are more likely to experience negative emotions that could lead us to change our investment strategy in the midst of a recession, when it is most damaging to sell stocks. Choosing a better anchor could help us weather recessions and stick with our strategy, ultimately helping our portfolio recover more quickly.
So how do we choose the right anchor? I suggest basing it on the risk profile of your investments. Using the table below, if you have a portfolio with 70% shares, you might consider cutting 29% of your investment values to calculate your anchor. In other words, if you have a million dollars invested 70% in stocks, you could anchor to a number close to $ 710,000. For someone with fewer stocks, who would normally experience less volatility, it would be reasonable to make a more modest adjustment to their anchor.
In essence, the anchoring effect is about the relative nature of our decision making based on the data to which we link our expectations. In the current environment of record home and equity prices, it is especially important to manage our expectations and know when to drop anchor.