Value Investing

Framing Effect And Investment Decisions – Part 8

The behaviour of individuals is affected by circumstances. More so, the behaviour is affected by the way in the circumstances are presented. Such is the effect of the behavioural biases! The biases modify the situation and circumstances in a way that the perception starts to differ. An individual with less bias will perceive the same situation differently from the individual with more bias.

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Framing Effect
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One such cognitive bias is the Framing Effect.

Framing Effect

Framing effect, in general, is the tendency of the people’s decisions to get affected by the way in which the choices are framed. The minds of individuals react differently to the information based on the way it is presented. The perception changes as a function of some variation in framing.

The framing effect has significant impact on investment decisions. The investment options are perceived differently by the investors based on whether is option presents more gains or more losses. The ultimate outcome of two choices may be the same, but the decision will depend upon which option is framed to present more positive outcome.

For example, an investor is presented with two scenarios. One in which he will gain $500 over the course of the year, but at the end of the year he will lose $100 of his profit due to market volatility. The second option is the one in which he will gain $500 over the course of the year and at the end of the year, he will be able to retain $400 of his profits. Now, the final outcome in both scenarios is a profit of $400, but since the second option is framed to present gain instead of loss, it will be preferred over the first one. This is due to the framing effect.

Causes of Framing Effect

The framing effect is the natural tendency of human perception. Humans have been trained and conditioned to look at the positive aspect in a more accepting manner, and the negative aspects are to be shunned.

Framing effect has also been discussed as a part of the Prospect Theory by Daniel Kahneman and Amos Tversky. Based on the theory, framing effect affects the investment decisions because a loss is more significant than the equivalent gain, a sure gain is favoured over a probabilistic gain and a probabilistic loss is preferred over a definite loss. So, the investors always look at the picture from an angle that presents gain.

Effects of Framing Effect

The framing effect has consistently been proven to be one of the strongest biases in decision making. As a result of framing effect, the investors tend to react to investment options inadequately. They accept or reject a proposal depending on the way it is framed. Even though the payoff is same, they will agree to the proposals portrayed as risky gains, and will reject the ones portrayed at risky losses. This makes the investment decisions inaccurate and clouded by bias.

Framing effect can also be used to trick the investors into certain schemes, investment vehicles and companies. The companies end up framing the information in such a way that their positives get glorified more than usual, and the competitors’ negatives are brought forth more than the actual. This will cause the investors to take incorrect decisions, leading to huge financial losses.

When a positive frame is presented to the investors, they are more likely to avoid risks; and when the negative frame is presented, they are more likely to seek risks. It is also important to note that the framing effect increases with age, thus the older investors are more affected than the younger ones.

How to Overcome Framing Effect?

There will always be the point where the data can be made to look positive or negative. It is the investors who have to ask themselves how reasonable their comparison is and how biased their decision will be based on the presented data.

Thus, the most effective way to overcome framing effect is to be aware of its presence. The investors must be vigilant enough to know that the data can be framed and presented to look different from what it actually is. This is when they will be able to make an informed and unbiased decision.

During investing, the gains and the losses need to be looked at realistically. The investors must not focus on the unrealised gains and losses. Focusing on the unrealized gains and losses will make them more susceptible to get affected by the framing effect. Instead, they must look at the practical aspects of the investment and make the decisions accordingly.