Primer | How framing effect works against logical investment behaviour

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Suppose you needed to register for an event. If I tell you there is a hundred rupees discount for early registration, you may or may not be tempted by it. But, if I warn you against a penalty of hundred rupees for late registration, you would feel a stronger push to register before the “deadline”. If we think about it, the two scenarios are logically equivalent – you pay less if you register before a date, and more if you pay later. Nevertheless, the way that the scenarios are framed (penalty v/s discount) messes with our rational thinking.

Similarly, aren’t we more likely to purchase milk labelled as 80 percent fat-free as opposed to a packet that is advertised as containing 20 percent fat? Mere framing can make us more likely to buy into something even when the alternative proposition is logically the same!

Kinds of framing effect

This is called the framing effect and is arguably one of the largest biases working against logical behaviour. It has been extensively researched, and is supported by Prospect theory which outlines what kind of framing influences which decision – we hate losses more than we love equivalent gains; when it comes to gains, we prefer certainty, but we go for uncertainty when dealing with losses. This is widely used by marketers worldwide. Politicians promise to “create jobs”, rather than reduce joblessness because it presents their promise in a positive frame. Medicines are advertised in terms of effectiveness, rather than failure – you are more likely to go for a medicine that is advertised as 90 percent effective as opposed to one that is said to not work 10 percent of the time. There is even a conspiracy theory floating about that ‘global warming’ has been renamed as ‘climate change’ to present it in a less negative frame.

Framing effect in investing

Considering the breadth of impact that the framing effect has, it should come as no surprise that the investing world is not spared either. Consider the “Mutual Funds Sahi Hai” campaign that highlights the benefits of mutual funds, but the disclaimer that mutual fund investments are subject to market risks is read out in a robotic voice at twice the speed at the very end. Even in direct stock investments, since management commentary materially influences analysts’ opinions and target prices, there is scope for management to over-emphasize achievements, and sweep the risks under the rug, thereby creating room for manipulation using framing effect. In the end, it is the retail investors who routinely and almost entirely depend on these ratings for their investment decisions that are hurt most. But that’s not to say that professional fund managers are left unscathed. It is not easy to avoid being blindsided by the swathes of false positivity flowing their way.

 What should investors do?

So, is there a way out? Research suggests that the influence of framing effect on an individual increase with age. This is intuitive considering that gut instinct is developed through experience and over time, and it is when you start trusting your gut with your decisions that you start falling for this bias. While a general solution to this still evades us, we have found a cure for it in the investment world. Quantitative Fund Management, as it is called these days, is as removed from its effect as one might wish for.

Quantitative fund managers base their investment decisions on facts and figures alone–earnings growth, leverage, market share, valuation multiple, and the like. When management commentary is used, it is only allowed at an arm’s length – scanned programmatically for facts while opinions are set aside. As should be obvious by now, this quantitative approach to money management is thus able to successfully sidestep all the traps laid out by framing effect. And not just the framing effect, this approach to fund management is almost immune to all behavioural biases.

We shall explore gambler’s fallacy in our next article.

[“source=moneycontrol”]