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Anchors: And You Thought You Had ‘Free Will'

By Steven GoldsteinMarket OverviewMay 24, 2012 08:41AM ET
www.investing.com/analysis/anchors:-and-you-thought-you-had-%E2%80%98free-will%27-124265
Anchors: And You Thought You Had ‘Free Will'
By Steven Goldstein   |  May 24, 2012 08:41AM ET
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'Anchoring' describes a tendency in our thinking process that leads us to become stuck on particular but largely irrelevant reference points that subsequently influence our judgements and decisions.

Anchoring was highlighted in a famous experiment by Nobel Prize winning behavioural psychologists Daniel Kahneman and Amos Tversky. In the study they asked participants to estimate the percentage of African countries in the United Nations. However before asking the question researchers exposed the respondents to an anchor. They were either asked :
 
"Is the percentage of African nations that are members of the United Nations more or less than 10%?" 

Or 

"Is the percentage of African nations that are members of the United Nations more or less than 65%?" 
 
The two numbers 10 and 65 are irrelevant to the question. However those that responded following the 10% anchor guessed on average 25%, and those who had been exposed to the 65% anchor guess on average 45%. The results suggested that the respondents anchored their answer to completely arbitrary numbers presented by the researchers.
 
How does this affect you as a trader? -- One of the effects is to become hooked on your entry level as a reference point, for example let’s say that I enter the market to buy EUR/USD FX because I want to go long, I would buy now at 1.2566, which would now become my reference point. I am likely to be influenced by this number. This could affect my judgement as I follow the market. Obviously it would not be the only factor, however it could sway me toward acting sub-optimally to this trade.

Suppose I place a stop a few points below yesterday’s low at a level of 1.2540, and decide to place a take profit 100 points higher than my entry level. Now assume the EUR/USD rallies this over the next couple of hours to 1.2610, then starts to stabilise around 1.2600. I may be tempted to move my stop up to my entry point, thus protecting my profits and avoiding a loss. This is by all measures a pretty sound strategy, but is it optimal in terms of trading? My original stop was placed somewhere a bit more relevant, below yesterday’s low point, now it is placed at a level that purely exists because that is where I entered the market; it's where my anchor lies.

Lets also look at other aspects of the trade, I placed and take profit 100 points above my entry at 1.2766, this is another arbitrary number, it relies on the original anchor. It fails to take into account other factors, such as levels of natural support or resistance, pivot levels, trend lines of key moving averages. It is also possible that sub-consciously this 1.2666 could continue to play an anchoring role throughout the day, influencing my trading judgment sub-consciously. 
 
Anchoring can affect us and our perceptions of value in all sorts of way in trading, investment and analysis that is not always to our benefit. When key data (E.g. U.S. payroll data) is released on every first Friday of the month, the entire market uses the estimates from economists as the anchor for whether the data is good or bad, rather than objectively assessing what this really means for the economy and markets. Too often the original reaction is irrelevant a couple of days later because a more objective assessment of the data has occurred as those traders still holding on to the original anchor can often be trampled over at this stage.
 
I am sure that we are also vulnerable to being anchored in beliefs that can be heavily influenced by exposure to information, a certain view point, or past experiences, which can lead to a sub-optimal evaluation of trading prospects. How might this occur, lets assume you are rather agnostic to rate views in a particular market. However someone hands you a report that suggests rates are likely to rise significantly in the next year, due to factors X, Y and Z. You read it and think you remain agnostic, that you are not bound to any beleif. But now it is quite possible that an anchor has been set in your mind and future views, beliefs and trades in that market, will be affected by that anchor, rather than a pure objective assessment.
 
I will use my own experiences from back in my much younger days to highlight an example: In 1994 I was trading German rate and Bund futures at a large investment bank, through 1994 the bond markets went in meltdown, everything pointed to much higher rates and inflation, it was to prove a very profitable year for me, I was on the right side of much of a very large move. - However the next couple of years proved tortuous, I think that in my mind I had become anchored to the fact that making money came from being short rate futures/long yields. Over the following 2 years the 1994 move was fully reversed, however I was regularly on the wrong side and missed some great trading opportunities.
 
If anchoring can affect people on an individual level, is it possible that anchoring can also affect the behaviour of the crowd, i.e. many individuals. It is common for traders to anchor their trading to key high and low points in the market, or previous levels of support or resistance -- in my example earlier I place my theoretical stop just below yesterday’s low. These levels can tend to exert an almost gravitational pull on the market, and traders will often place ‘take profits’, ‘stop losses’, exits and entries in relation to these key levels, hence we tend to see volume peak at these key price points (users of ‘Market Profile’ will of course be familiar with this). It is very common for traders to feel that the market is seeking stops, and many trades become paranoid that the big market-makers and players are teasing with the market, however in terms of anchoring, we can see how much of this is almost a natural phenomenon. 
 
I come back to the original statement in the title of this post, ‘You thought you had ‘free will’ ’. ‘Free will’ would imply that you have complete objectivity in your decision making and perception, and complete freedom to make your own choices. I am afraid to say that sadly that may not be the case. However, familiarity with this behavioural biases, such as anchoring, may start to improve your trading, if you understand the way this affects markets and yourself, perhaps you can start to make small adjustments in your behaviour that can improve your trading performance.
Anchors: And You Thought You Had ‘Free Will'
 

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Anchors: And You Thought You Had ‘Free Will'

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