Cognitive Biases
We're all subject to cognitive biases, logical fallacies, and plain old illusions. Don't believe it?
Have you ever gone to a store and seen an item being sold as 2 for $2? You, like most people, probably bought two of the items (if you needed it). After all, it's on sale, right? Not necessarily. Had you checked the unit price (in small print) you might've seen that each unit was $1. There was no sale, but the ad was framed as one.
This is an everyday example of the framing effect. It applies to the world of finance as much as it does elsewhere. In this lesson, we define this effect and then go over some examples of it as it pertains to risk management.
What Is the Framing Effect?
The framing effect, sometimes called framing bias or simply framing, is a type of cognitive bias where a person's decision is affected by the way the information about the decision is presented, or framed. In other words, framing refers to alternative representations of the same objective information that end up significantly altering a person's assumptions, models, and ultimate decisions about that information.
Most people will prefer an outcome that is presented in a positive light as opposed to a negative light, despite the same end in sight. For instance, a politician who employs an economic policy of increasing the employment rate (employment is positive) as opposed to decreasing the unemployment rate (unemployment is negative) may have more success simply because of framing the same issue in a different light.
All of what we just went over works in the world of risk management as well.
Examples
A very simple example of the framing effect in investments can be the following:
- A.) We may gain 25% if we invest in stock X
and/or
- B.) We may lose 100% if we invest in stock X
We have a situation that involves a 25% upside and a 100% downside risk (as with every investment), yet the way we frame the decision can significantly impact whether or not we invest. If the S&P 500 has gained about 8% (after inflation) for the past decade, then A seems like a positively amazing opportunity to beat the market!
Not surprisingly, studies have shown that, with respect to risk management, people are more likely to enter into a risky situation (such as starting a new business) when the perception of risk is low as a result of framing.
Here's a really good example of this. Let's say you are managing a client's money and are seeking to invest it into a startup. The startup is run by a serial entrepreneur with a couple of commendable successes under his belt. He tells you, and your research confirms, that if the start-up succeeds you can double your client's money in about a year.
In order for this to occur, the following events must occur. We assume they are independent of one another for simplicity's sake:
- Gain 1% market share in a year: Chances of success = 75%
- Build a fully functional production plant within a year: Chances of success = 75%
- Recruit a highly talented professional to run the organization: Chances of success = 75%
- A year after launch, sell the company for a massive profit: Chances of success = 75%
So it seems like there's a 75% chance of doubling your client's money in a year and only a 25% chance of losing everything! In the long run, that is a truly amazing opportunity.
Is it though? Via the framing effect, it appears to be so yet if we look at the same information in a different light, this is actually a risky venture (as any startup would be).
Even if we assume the rosy 75% figures are all correct, the chances of success for all independent events are actually 0.75 raised to the power of four. This means our chances of all four of those independent events coming to fruition are actually less than 32%. Re-framing the same situation has yielded a completely different perspective on the risks involved here. There's a 68% chance your client will lose all of his money.
Avoiding the Framing Effect
So how can we apply what we know towards avoiding the framing effect? There are two potential strategies which might reduce (but not eliminate) the framing effect from decision-making in risky situations.
One of them involves thinking about all of the possible good and bad circumstances surrounding, and outcomes occurring as a result of, a decision. In other words: force yourself to play devil's advocate as much as possible.
Another potential way to reduce the framing effect with respect to risk management specifically is to manage other people's money. Some research has shown that when we manage other people's money, we aren't as emotional about our decisions, and this helps minimize framing bias. Of course, it does open one up to plenty of other biases that can doom an investment, but that's for another lesson.
Lesson Summary
Let's take a couple of moments to review what we've learned. The framing effect, sometimes referred to as the framing bias or simply framing, is a cognitive bias where despite the same objective information the way that information is presented subjectively significantly influences decision making. The framing effect is important to keep in mind in the world of risk management as it can lead to us making unsound judgments and investments when we only look at the positive side of things.
To help mitigate the framing effect, we must always look for all the pertinent positive and negative information that helps us reach a decision and, perhaps, manage other people's money as this helps avoid emotional decision-making that makes the framing effect even worse.
