Economic decision makers aren't as detached, emotionless and rational as traditional theorists have portrayed them to be.
However, when it comes time to make financial and investment decisions, we are prone to err based on many factors. These include the context in which the choice is formulated or framed, the personal characteristics of the decision makers, and the perspective from where we view the decision.
Let's define framing as a cognitive bias in which people jump to diametrically different conclusions according to the way a question is presented.
"You do everything in your power to try and keep people on the straight and narrow and do what they need to do, but they still want to do the exciting thing du jour," said Daniel Crosby, a psychologist and behavioral finance expert.
For instance, as a general rule, during an initial public offering the narrative around the issuing is positive, creating a framing bias that can drive investors toward risk-seeking behavior for fear of missing out on a bonanza.
"You need to help clients understand that on average IPOs under-perform the benchmark by 21% three years on because they're born on excitement," said Crosby, who is president of Nocturne Capital in Atlanta. "They're born on irrational exuberance, and people tend to do IPOs, of course, as we all know, when the market is relatively elevated or there's a lot of popular sentiment."
Consider the following example, from Daniel Kahneman, a professor at Princeton University and a Nobel laureate in economic sciences, and his friend, the late psychologist Amos Tversky, who co-authored many important pieces on behavioral economics.
Would you accept a gamble that offers a 10% chance to win $95 and a 90% chance to lose $5? Would you pay $5 to participate in a lottery that offers a 10% chance to win $100 and a 90% change to win nothing?
A rational or "reality bound" actor as defined by Kahneman in his book Think Fast and Slow (Farrar, Straus and Giroux, 2013) would give the same answer to both questions.
However, the second question is more acceptable, as it is presented in the form of a lottery that didn't pay off rather than as a losing gamble, according to Kahneman.
The way in which a choice is presented can lead us to assume a posture that could go against our interests. Losses loom larger than gains, so when questions are presented in a "loss" frame, a risk-seeking response is more likely, whereas if the choice is presented as a "gain," the risk-averse response is more prevalent.
"Framing is a psychological effect that gives us a frame of reference, a position or a set of beliefs or values that help us filter and interpret facts and situations as we make choices," said Stan Clark. He is the first vice president, portfolio manager and senior investment adviser at the Stan Clark Financial Team at CIBC Wood Gundy in Vancouver, British Columbia.
"Framing helps us to understand our world," Clark said. "It's an instinctive behavior initiated by System 1, the part of our thinking that is reflexive, fast and intuitive."
Clark's idea about how framing operates can be illustrated with the following example: If you take a cab in New York, and pay with a credit card, you will then ask yourself what is a reasonable tip: 15%, 17% or maybe 20%.
However, did you notice that the "suggested" tip on the screen is 25%, 30% or 35% of the total fare? You have the option to choose the lowest tip, but the cars are honking behind you, you are late for your appointment or you simply want to get home.
In the end, you are more likely to choose the middle option, 30%. Without the choices on the screen, however, you had been more likely to pay either 15% or 17%.
Simply put, the taxi company is using both the framing and your impatience to readjust your own opinion of "fairness" in terms of the tip amount.
As we have seen, framing bias can lead investors to respond to questions about risk that could be unreasonably aggressive or conservative. The optimistic or pessimistic frame for an allocation or asset recommendation can affect people's attitude toward an investment.
A question framed "optimistically" is more likely to generate an affirmative response.
The frame of choices whose result would be similar shouldn't have any bearing on the investor's answer, but it does.
This article is commentary by an independent contributor.