- Anchoring can be a powerful tool in negotiations: once an anchor has been established, it sets the reference point for future discussions
- But anchoring is also a dangerous bias in the investment world
The UK’s summer of discontent rumbles on. After extended rail strikes last week, the National Education Union (NEU) is advancing plans for an autumn teachers strike, and the Royal College of Nursing Union (RCN) has warned the government that "a pay rise that goes significantly above inflation is crucial to the recruitment and retention of skilled nursing staff".
Headlines seem to be dominated by a series of seemingly irreconcilable figures. The RMT is pushing for a ‘fair settlement’, keeping pace with (higher) RPI inflation at 11.7 per cent, and the RCN is looking for an inflation-busting pay rise of at least 14 per cent. All the while, the government urges pay restraint, fearing that every pay deal will become a starting point for the next negotiation: last week saw a civil service pay rise of just 2-3 per approved for 2022-2023,
These numbers appear stubbornly far apart. Surely the government realises the misery of asking workers to take what is in effect a real terms wage cut? Don’t unions understand fears of a wage-price spiral? Perhaps. But that doesn't mean that negotiations are doomed to fail: it might be a case of ‘anchoring’ at play.
Anchoring in behavioural economics describes the tendency to rely on the first piece of information offered (the ‘anchor’) when making decisions. It can be a powerful tool in negotiations: once an anchor has been set, we tend to interpret subsequent information around that anchor. If a union initially demands a 15 per cent pay rise, an above-inflation 10 per cent increase suddenly sounds more reasonable.
And the government is trying to set its own ‘anchor’ by offering public sector pay rises of 2 per cent: this is, after all, the UK’s target rate of inflation. The 2 per cent offer is perhaps also designed to remind workers that high inflation is forecast to be short term. It also frames negotiations in the context of a more ‘normal’ economic environment: against an anchor of 2 per cent, a 4 per cent nominal pay rise starts to look slightly more generous.
In a negotiation, both parties often have a walk-away (reservation) price that differs significantly from the anchor they set. This means that in reality, parties can reach a mutually acceptable outcome by moving towards their walk-away prices and agreeing other concessions. These could take the shape of redundancy protections for railway workers or workload pledges for teachers.
Bonuses are another possible negotiating tool. These allow a one-off pay rise to help workers keep pace with inflation, but don’t commit firms to irreversibly higher pay. As such, they may also help to allay fears of an inflationary spiral. As my chart shows, strong bonus payments are keeping total inflation adjusted pay growth positive. Bonuses are also pushing ahead of regular pay at the fastest rate since the financial crisis. Although not evenly spread, don’t think that they only apply to bankers – according to the ONS, bonus pay was high across multiple sectors in April 2022.
But while anchoring helps to influence negotiations, it carries with it a high chance of disappointment. After all, when we set our sights so high, even an acceptable middle-ground can feel like a setback. Harvard Law School’s Program on Negotiation recommends focusing on the ambitious goal during the negotiation, but comparing the outcome to the walk-away price after the negotiation is complete.
This could be a useful lesson for investors, too: anchoring is a common bias in the investment world. A 2008 study by Markku Kaustia, Eeva Alho and Vesa Puttonen from the Helsinki School of Economics found that both novice investors and professionals experienced an anchoring effect. When exposed to a higher initial starting value, professionals gave return estimates around 2 per cent higher than those exposed to a low anchor. The anchoring effect on inexperienced students was even greater.
Another common trap is taking high historical returns as a reference point and building expectations around them – even as less favourable evidence begins to emerge. Although anchoring can be a useful rule of thumb, remember your walk-away price too.