Monday, March 12, 2012

Why we sometimes make bad decisions: The anchoring and adjustment heuristic

How much to pay for the house of your dreams
Imagine you are interested in buying a house and you've been out looking on the weekends. You find a 3 bedroom, 2 bath bungalow on a quiet street that already feels like home. The asking price is $475,000 (for those of us living in pricier areas, play along by imagining it's 1995). You want the house, but you don't want to pay too much. You've noticed other comparable homes in the area seem to go for anything from $350,000 to $600,000. So how much do you offer? Have a number in mind? Now, read through the scenario again, but this time imagine that the asking price is $439,999. How much would you offer then? Do you come up with a different number?

Let's try a different example: First, what are the last two digits of your telephone number? Got that number in mind? Now, I'd like you to think about what percentage of African countries are in the United Nations. Do you think there are more or less than the telephone number? How many more or less? Amos Tversky and Daniel Kahneman did a similar study in their seminal 1974 paper on biases in judgment and they found that people who had a lower number (after spinning a wheel of fortune) estimated fewer countries than people who had a higher number. For example, the median answer for people who spun a '10' was 25%, whereas the median answer for people who spun a '65' was 45%. So why does a random number influence our judgment about something unrelated?

This little trick is referred to as the anchoring and adjustment heuristic. Heuristics are mental shortcuts that we use to help quickly make judgments and decisions. We need these mental shortcuts because we wouldn't be able leave the house in the morning if we had to conduct a thorough program of research before making every decision. However, there are times when these mental shortcuts do not lead to good decision making, and so it is important to be aware of them and know when, and how, to override them. Also, it’s just plain entertaining to try out these fun mental tricks on yourself (and others).

The anchoring and adjustment heuristic is just one of many heuristics, and it is just what it sounds like. We tend to anchor onto a primary piece of information, and then iteratively adjust away from that piece of information until we reach a decision that seems reasonable to us. This heuristic can be very useful when the primary piece of information does hint to a correct answer and is relevant to the decision at hand. For example, with real estate, a house's asking price should be somewhat related to the house's actual value.

But what about situations where the primary piece of information is not a good anchor? The African countries example is one such case, but it's not a very good real world example. However, real estate is also ripe with these types of situations: There are times when sellers ask for a much lower price than they really want, hoping to start a bidding war. Other times, sellers see more value in their homes than is actually there, and ask for a price so high that no buyer is going to take the bait. In these situations, the asking price is not a good anchor, but it still may play a role in helping buyers decide how much to offer. When the price is too high or too low, the buyer will, of course, offer something different than what is being asked. But the question here is, how much different? Let's say that there is a house worth something between $450K and $500K. In one case, the owners ask for $425K in the hopes that they will get lots of interest and people will outbid each other. They might get a bunch of offers higher than asking, but how high will they actually be? In the other case, the owners ask for $525K, perhaps because they bought it when the market was higher and can’t bear to sell for less. This asking price is clearly more than the house is worth, and buyers will offer below asking, but how much below? In both of these cases, people are still likely to use the initial asking price as an anchor and adjust their offers up or down from this price accordingly. In both cases, the house is worth the same and people should end up offering somewhere around 475K, but if people do apply the anchoring and adjustment heuristic, in the end, the higher priced house might ultimately go for more.*

Anchoring and adjustment doesn't just happen with numbers - researchers have also found that this type of heuristic impacts people's perspective taking. When trying to decide how someone else feels, we start by anchoring onto how we would feel in the situation and then begin to adjust that for how we think the other person might feel. Typically, though, we don't adjust far enough and end up with an egocentric bias, believing that other people think and feel more like us than they actually do.

Photo by Giorgio Montersino
How do we avoid finding ourselves as unwitting prey to this heuristic? Simply knowing about the heuristic can help, but that may not be enough. Another trick is to try to estimate a range of numbers or feelings, rather than pinpoint a specific estimate. Researchers argue that this is because we are aware of the range of reasonable answers, but when we are anchoring and adjusting to a specific number, we just move up or down until we get to the edge of the reasonable range, and stop there. So if a house is worth somewhere between $450K and $500K and the asking price is $425K, then once you get up to $450K and you are in the acceptable range, you are likely to stop and say, this is it!

 Also, don't be fooled by those decimal places! Researchers have also found that precise anchors lead to smaller adjustments than less precise anchors. What does this mean? If you were trying to decide how much to bid on an item at an auction, you'd bid closer to the asking price if it was more precise ($49.98 versus $50). According to the researchers, this happens because you are making adjustments using the same scale as the anchor. Think back on the first example of this post - did you stay closer to the asking price when it was $439,999 than when it was $475,000?

Did the examples work on you? Put your estimate for the African countries and the last two digits of your phone number in the comments! 

The articles:

  • Tversky, A., & Kahneman, D. (1974). Judgment under Uncertainty: Heuristics and Biases Science, 185 (4157), 1124-1131 DOI: 10.1126/science.185.4157.1124
  • Epley, N., & Gilovich, T. (2006). The Anchoring-and-Adjustment Heuristic: Why the Adjustments Are Insufficient Psychological Science, 17 (4), 311-318 DOI: 10.1111/j.1467-9280.2006.01704.x
  • Epley, N., Keysar, B., Van Boven, L., & Gilovich, T. (2004). Perspective Taking as Egocentric Anchoring and Adjustment. Journal of Personality and Social Psychology, 87 (3), 327-339 DOI: 10.1037/0022-3514.87.3.327
  • Janiszewski C, & Uy D (2008). Precision of the anchor influences the amount of adjustment. Psychological science, 19 (2), 121-7 PMID: 18271859

 *Please do not take this as real estate advice! These are very simple examples used to illustrate a point.

1 comment:

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