Last week we looked at loss aversion, which segues nicely into a discussion of the cognitive bias known as framing. Our aversion to loss can explain the effects of framing.
An example can best describe the concept of framing: let’s assume you are in a shopping centre, standing outside both Harvey Norman and JB Hi-Fi, and you are looking to buy a TV. Harvey Norman is offering the one you are after for $1000, while JB Hi-Fi is offering the same one for $950. However, Harvey Norman is also offering a $50 discount for cash, while JB Hi-Fi charges a $50 surcharge for credit cards. All other things being equal, which store would you buy from? Most people report a preference for Harvey Norman, the store offering a cash discount.
This tendency is interesting, as both stores are offering exactly the same deal: a price of $950 for cash or $1000 for a credit card. But this preference can be explained in terms of how the question or problem is framed. Humans evaluate outcomes in terms of losses and gains from their current, neutral state, which can be described as a starting point of sorts. In the Harvey Norman example, it appears your starting point is $1000, and you are then offered a saving of some money, which is a gain or improvement from your starting point. However, in the JB Hi-Fi example, your starting point is $950; however, you are faced with a potential price increase, which is a loss or deterioration from your starting point.
The psychology behind this relates to what we discussed in last week’s article on loss aversion: humans treat losses of a given amount far more seriously than gains of an equivalent amount. Again, we can refer back to the Rivkin rule that states ‘the pain of losing money is greater than the pleasure of making money’.
So how exactly does framing relate to investing? The best way to answer this is to give you the following, rather well-known example that I included in my book on share investing many years ago. Assume that the outbreak of a new pandemic (not so difficult to imagine these days!) is expected to kill 600 people. Assume also that two alternative programs have been proposed to address the problem. In the first set of options, Program A will result in 200 people being saved, whereas Program B will result in a one-third probability that 600 people will be saved, but a two-thirds chance that no one will be saved. Roughly 75 percent of people elect Program A as the preferable one.
Now let’s examine the second set of options: Program C will result in the death of 400 people, whereas Program D will result in a one-third probability that no one will die, but a two-thirds probability that 600 people will die. Roughly 75 percent of people choose Program D as the preferable one. This leaning is fascinating when you consider that Program A is the same as Program C, but framed differently, and Program B is the same as Program D, but again framed differently. Yet people report a preference for programs A and D!
The reason for this is that when information is framed as a gain, people generally go with the guaranteed option. However, when information is framed as a loss, people typically go with the risky option. The first set of options used the word ‘save’ (framed as a gain), whereas the second set of options used the word ‘die’ (framed as a loss).
This phenomenon is also seen in the share market and relates very much to loss aversion. When making money on an investment (a gain), people often take the guaranteed option by taking profits and locking in that ‘guaranteed’ gain. However, when losing money on an investment (a loss), most people choose to take the risky option by running losses and holding the stock. And yet, as discussed in last week’s article, any market expert will tell you that “good investors” do the exact opposite – they cut their losses and run their profits.
Try to bear in mind that, on account of the phenomenon of framing, your instincts are pushing you to take your profits and run your losses. Do your best not to succumb to this, because cutting losses and running profits makes for a far wiser course of action.
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