Wouldn't you rather buy meat that’s labelled 75% lean as opposed to 25% fat? The answer inevitably is yes, but how do you know you have made the right choice?
The way products are presented to us has a dramatic effect on what we buy and how we feel about what we buy. While identical, we inevitably feel better about buying meat that is three quarters ‘lean’ than a quarter ‘fat’ because of a natural susceptibility to value losses, or negative facts, more significantly than gains and positivity.
It’s this predisposition that marketers capitalise on to sell products and what investors get stung for when they believe they’re making the right choices when in actual fact they’re not.
Behavioural psychologists dub this ‘framing’ and they’re now trying to show investors when they are being framed and when they are not.
The term framing hit the mainstream in 2011 when Nobel laureate, Daniel Kahneman published his book 'Thinking Fast and Slow' which explains how framing prevents humans from making the best choices in life.
In a famous example by Kahneman and his now deceased colleague, Amos Tversky, people were asked to choose between two treatments to save 600 people from dying from an Asian disease.
Participants, including physicians, were asked to choose between a certain outcome that 200 people will be saved and a riskier choice where there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved.
In a second example, the group were asked to choose between allowing 400 people to die or a one-third probability that nobody will die and a two-thirds probability that 600 people will die.
In both examples, the first choices have an identical outcome as do their second alternatives. But faced with such a grave choice people did not spot the similarities. In the first example people opted to save 200 people over the gamble of losing people and in the second example people preferred the gamble over the certain outcome of killing 400 people.
Investors hate losses
Still with us? What the experiment shows is that wording, or rather framing, can have potentially dangerous consequences. The reason the majority of people chose either a certainty of 'saving lives' or the one-third probability that nobody will die is simply a matter of presentation.
And as humans we are hardwired to try to prevent loss. According to research done by Kahneman and Tversky in 1970s we tend to feel losses much more strongly than the pleasure of making a comparable gain.
Positive-framing is therefore a sure way to get investors to part with their money.
“Talking about past gains and not losses makes a huge difference to how investors perceive their portfolio and marketers know this all too well,” said Peter Brooks, a behavioural expert from Barclays.
Compounding this fact, Terrance Odean from the Haas School of Business in California found that people were one and a half to two times as likely to sell a stock for a gain than for a loss.
Odean studied swathes of US investors and found that more often than not investors are ruled by an emotional need to prevent loss, leading them to sell their winners for a quick gain and keep their losers.
“People get affected by whether they view the sale as a gain or a loss, even though it's not relevant to the decision in terms of the future investment,” said Odean.
He found the losers that they held onto went on to underperform not outperform the winners they sold.
Brooks has noticed the same bias in his clients: “People will sell their winning positions, lock in the gain, boosting their ego.”
Thus many sit on their losing stock because taking a losing position makes them feel bad.
“It hurts and therefore people don’t want to do it,” said Brooks.
Take a step back
The daily ructions of the market can also lead investors astray. The ups and downs make the tendency to look at the portfolio's performance frequently too tempting. This means investors are likely to perceive more risk, forgetting about their long term goals.
When investors log into their trading accounts they can see the potential gain or loss of all of their assets. They can also see the day change on assets which are coded gain and loss. Brooks believes that those who look less get more.
“If you look at FTSE index from today to tomorrow there is a roughly 50% chance that it has gone up or down. If you look at it over a year you may find that 60-65% of the time it is going up. And if you look over a five year period you will find that 90% of the time it goes up,” he explained.
Investors who want to steer clear of the daily market tumult could try computer-generated index funds, a type of mutual fund with a portfolio that matches the movements of a market index, such as the S&P 500, said Arvid Hoffmann, assistant professor of finance at Maastricht University in the Netherlands.
But while these may provide a cheap way to keep a healthy distance from your investments, they are not as exciting as fighting your own way through the market.
Behaviouralists, like Brooks, try to help investors recognise this kind of framing and shift their focus to information that is actually relevant.
“We are trying to challenge the traditional way of presenting information to customers.”
Brooks and his team meet clients directly to talk them through how their biases and decision-making help or hinder their investment strategy.
And like many behaviouralists, Brooks admits that while it may be impossible for humans to beat their instincts, at least they can try to stop their instincts from beating them.
“This is not an attempt to get to perfection,” he insisted. “It's more a case of capturing back some of the underperformance created by our own psychology.”
Or as Voltaire once wrote: Don't let the perfect be the enemy of the good.
Long-term investment success is not just about developing investment skills, it's also about discipline. A common bias that investors can suffer from is "Framing Bias". This is the tendency to behave differently depending on how a situation is presented to us. Watch more about the factors affecting investment behaviour, such as framing, at investmentphilosophy.com.