This week we are going to examine what is known as Framing Bias.
The following example of framing bias was written by Steven Novella and published in Neurologica Blog. “Let’s say you need a surgical procedure and the surgeon tells you there is a 98% survival rate with the procedure. How would you feel about that? What if she told you there was a 2% mortality rate? Would you feel the same way? Probably not, according to years of psychological research.
This is known as framing bias, just one more of the many ways in which our brains are biased in the way we evaluate information. The two scenarios above are identical, but statistically people will make different decisions based upon how the information is framed. We generally respond better to positively framed information (98% survival) than to negatively framed information (2% mortality).
The framing effect is often exploited by those who are deliberately trying to manipulate our reactions. Politicians, for example, can talk about employment rates or unemployment rates. Events can give you an early-bird discount or a late registration penalty. Products can have 4% fat or be 96% fat free.
Framing is another way in which we construct our picture of realty, by deciding what information is important.”
So how does framing bias effect investors?
According to Michael M. Pompian, author of Behavioral Finance and Wealth Management, investors exhibiting this bias can make the following four mistakes:
- Depending on how questions are asked, framing bias can cause investors to communicate responses to questions about risk tolerance that are either unduly conservative or unduly aggressive. For example, when questions are worded in the “gain” frame, a risk-averse response is more likely. When questions are worded in the “loss” frame, risk-seeking behavior is the likely response.
- The optimistic or pessimistic manner in which an investment or asset allocation recommendation is framed can affect people’s willingness or lack of willingness to invest. Optimistically worded questions are more likely to garner affirmative responses, and optimistically worded answer choices are more likely to be selected than pessimistically phrased alternatives. Framing contexts are often arbitrary and uncorrelated and therefore shouldn’t impact investors’ judgments … but, they do.
- Narrow framing, a subset of framing bias, can cause even long-term investors to obsess over short-term price fluctuations in a single industry or stock. This behavior works in concert with myopic loss aversion: The risk here is that by focusing only on short-term market fluctuations, excessive trading may be the result. This trading behavior has proven to be less than optimal for investors.
- Framing and loss aversion can work together to explain excessive risk aversion. An investor who has incurred a net loss becomes likelier to select a riskier investment, whereas a net gainer feels predisposed toward less risky alternatives.
Let us help you eliminate this bias. Professional advisors with disciplined systems of investing tailored specifically to your investment goals will allow you to overcome many of the obstacles inherent in our very nature. At DWAM, we can help.