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Traditional economic theory assumes that investors are completely rational beings. Hence, they react to information in the same way if the content of the information is the same. However, behavioral finance theory seems to disagree with this assumption. According to them, investors interpret information in different ways if it is presented to them differently. This different interpretation can have an effect on the way they make investment decisions. In behavioral finance, this is known as the framing bias. In this article, we will understand what framing bias is and how it impacts decision making.
In simple words, framing bias means that the investors are more responsive to the context in which information is presented as opposed to the content of the information. This can be seen from the fact that investors react to the same information differently if it is presented in a different context.
Framing bias also has some subtypes. For instance, there is a phenomenon known as "narrow framing." In this phenomenon, the investors focus only on a few aspects of an investment to the exclusion of everything else. For instance, some investors might be too focused on the price-earnings ratio of a stock and may not pay attention to all other data, which is obviously very important in the valuation of a stock. Narrow framing is basically a mental shortcut that brings about oversimplification. Investors try to reduce the complex activity of valuation of stock to the performance of one single metric. That is not how the world works, and sooner or later, this method is bound to fail!
It is a known fact that framing elicits different responses from investors. Some of the most commonly quoted examples are mentioned below:
When investors are presented with a situation in which they have already gained something, they are likely to protect it and subscribe to a risk reduction mentality. However, when investors are presented with a situation in which they have lost money, they are likely to subscribe to a more risk-taking mentality.
Investors can be induced to invest in an opportunity if the details related to that investment are framed optimistically. For instance, an investor is only shown details about the gains with very little information about the risks; they are likely to ignore the risks and make the investment. On the other hand, if the same investment is frame negatively, and the focus is on risks, the investor is more likely to back off from an investment decision.
The framing bias is also closely related to loss aversion bias. When an investment is framed in the context of a loss, it can appeal to the investors' innate loss aversion behavior and can elicit certain types of responses.
The framing does not have to be done by other individuals or salespeople. Situations automatically provide frames of reference. For instance, if an investor has lost money in the previous trades, they are in a negative frame of reference. On the other hand, if they have gained money or if the equity market is on an upward trend, they are in a positive frame of reference. Investors find it impossible to disconnect and consider each trade on its individual merits. They tend to look at trading as a sequential activity wherein the results of their previous tasks spill over to their future tasks.
The fact of the matter remains that ideally, framing shouldn't have any response on a rational investor's behavior. However, it does have a response. Hence, we can be sure of the fact that investors are not completely rational.
Once we recognize that framing can impact investor behavior, the next step is to understand what are the efforts we can undertake in order to avoid this bias. Some of the common steps have been listed below:
Investors must try not to use investment shortcuts. They must not look at individual metrics such as debt to equity ratio or price to earnings ratio only in isolation. Also, they must not pay too much attention to short term movements which are restricted to a particular stock or a particular industry.
Investors must try to pay attention to the larger picture of wealth creation. They must not get emotionally attached and invest only in them while remaining oblivious to other asset classes.
Investors should consciously make an attempt to separate each trade from the previous ones. Most of the time, the reference is automatically created by previous trades. By looking at each decision in isolation, an investor is likely to make better decisions. It is important for investors to consciously choose neutral references. Even if financial salespeople are trying to modify the reference, investors must train themselves to hang on to the reference.
The fact of the matter is that our minds are trained to make decisions subconsciously, and framing appeals to the subconscious. It takes conscious training on behalf of the investors to subdue the effects of framing on their minds.
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