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Tuesday, October 24, 2006

Anchoring and The Psychology of Selling

Images_89 There is an interesting article in the LA Times about the psychology of selling a home.  The story goes like this: say you bought your home ten years ago for $250,000.  Now you're thinking of selling it.  You put it on the market for $600,000.  No takers.  You reduce the price to $575,000, then to $550,000.  An offer finally comes in for $520,000, which you reject.  Then, you take the house of the market and wait for "better times" to sell.  Apparently, this is common in places where the real estate market was previously much "hotter."  Why are homeowners doing this?  Is this behavior rational?  What is the right price for your house?

There are at least two ways for the seller to look at the situation: (1) $520,000-250,000 = I've more than doubled my money considering what I paid 10 years ago or, alternatively, (2) $600,000 - $520,000 = feels like a sizable loss because I asked for $80,000 more.   Which one is the rational view?  Perhaps cognitive psychology helps explain the behavior:

Decades of research in decision-making has taught us that people depend a great deal on such anchors, or frames of comparison, in assessing the value of any deal. Unlike expectations, which are consciously held attitudes, people are influenced by anchors without even realizing it. If you ask college students if the average price of a textbook is more or less that $7,000, they look at you like you're crazy and say "less, of course." If you ask other students if the average price of a textbook is more or less than $12, they wonder if you've been asleep for 30 years and say "more, of course." Then ask both groups of students what they think the average price of a textbook actually is, and the first group will give an estimate that is more than twice the second group's. Even though the starting point that you've imposed on each group ($7,000 or $12) is absurd, it nonetheless anchors their subsequent estimate, though they don't realize it.

Is $279 a lot of money to spend on an automatic bread maker? When Williams-Sonoma first marketed these then-novel gadgets more than 20 years ago, no shopper knew what a bread maker ought to cost, and Williams-Sonoma didn't sell a lot of them. Then it introduced a deluxe, $450 model. The company didn't sell many of these either, but sales of the $279 model went through the roof. The deluxe bread maker made the regular one seem like a bargain. Conclusion: We are affected by anchors whether it's rational or not, whether we want to be or not.

And so, when irrational exuberance induces people in hot housing markets to put very high asking prices on their houses, the asking price, and not their original purchase price, will be the anchor for some, and having to come down from that price will hurt. How can $520,000 sting so much when it's actually a huge capital gain? Because another thing we have learned from research on decision-making is that people hate to suffer losses — and they feel far more pain from the loss of a sum of money than they experience pleasure from the gain of the same sum.

* * *

Knowing these quirks in decision-making helps us understand why some people take their houses off the market even when they stand to make a very large profit by selling them. Having been seduced — by real estate agents, by the media, by their neighbors — to set a high anchor, they will feel like losers even when they double their money.

The effects of "anchoring" permeate all of our decisions: political choices, choices whether to sell or hold stocks.  This is not the newest of ideas in academic circles, but, as evidenced by the newspaper article, these ideas are becoming part of popular psychology. 

[Meredith R. Miller]

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