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framing how we think about our moneydecember 2012 “I used to think that the human brain was the most
fascinating part of the body. Then I thought, what part of
my body is telling me that?”
“Rose coloured glasses are never made in bifocals.
- Erno Philips (American entertainer/Actor) Nobody ever wants to read the small print in dreams.”
- Ann Landers (Agony-aunt for the Chicago Sun-times 1943) How often do we stop to think about how we think? As a species we have made great industrial and technological Framing bias is fondly known as the “tinted spectacles progress over the last few centuries, but thousands of effect”. Framing bias occurs when our decision (for example years of evolution have not changed the way our brains to take risk or not) is influenced by how the question is put are pre-programmed to think. For example, we still use our caveman fight or flight mode to make decisions in the twenty-first century. So much for evolution! Admittedly, Nobel laureate Daniel Kahneman worked with Amos fight or flight may be useful in a dark alley but, as we Tversky to study the effect of framing bias when it came demonstrate, when it comes to investing it is disastrous.
to making investment decisions. In 1979 they developed Prospect Theory, a theory that describes how people make The modern human nervous system is comprised of decisions between alternatives that involve risk. They approximately 100 billion neural functioning cells, observed that when making investment decisions which supported by what has been estimated to be almost ten involve risk, humans have a tendency to take more risk with times that number of other “supporting” cells. The cabbage their investments when they are showing a loss and less like structure making up our cerebral cortex is still largely a risk with their investments when they have a profit.
mystery to medical science. For most of us, mastering the emotional signals our brain sends out is a lifelong voyage In one of their studies, Kahneman and Tversky offered of discovery. Not surprisingly humankind has developed participants one of the following choices: tools to help, such as anger management groups or Prozac for depression. What is surprising is that, until recently, • Situation A: a sure gain of $240; or there has been little research into whether our brain, and • Situation B: a 25% chance to gain $1000 and a75% chance the emotions it creates, is harmful or useful when we In the above situation, 84% of people surveyed chose Studies show our brain is a learning organ. Experiences the more certain situation A. Kahneman and Tversky then from previous events and their outcomes are stored for offered the same participants one of the following choices: future reference and these create responses when the event re-occurs. When a past outcome had pain associated • Situation C: a sure loss of $750; or with it our brain teaches us to avoid it in the future.
• Situation D: a 75% chance of losing $1000 and a 25% chance of losing nothing.
So far so good, but this learning mechanism sometimes works to our detriment. This is certainly the case when it All of a sudden the same people were willing to gamble comes to dealing with complex or unpredictable events with their money! 73% chose the more uncertain outcome, like investment markets. What may on the surface look like a similar situation to one we have encountered in the past (with painful consequences), can in fact be very different The way the situation was presented (or as technicians say, when carefully analysed in the cold light of day - without “the framing of the question”) actually changed peoples’ our pre-programmed emotional response. In short, when it investment behavior. Situations B and D have higher comes to investing, our brains play tricks on us.
expected value than situations A and C, yet investors chose one high expected return and one low expected return. The example highlights that when emotions kick in we do not invest like the cool, calm and calculated machines we aspire to be but instead begin to gamble in desperation, often with disastrous outcomes.
The first step toward creating a solution is recognising that there is a problem. As a consequence, we put considerable effort into researching not only which investments to put into our clients’ portfolios but also how clients will feel “It is difficult to live in the present, ridiculous to live in
about their financial plan over time. Our objective is to the future, and impossible to live in the past. Nothing is
structure and manage clients’ investments in a manner that as far away as one minute ago.”
does not put them in the position where they have to make - Jim Bishop (Journalist for New York Daily Mirror 1930-1943) an emotionally charged – and possibly irrational – decision.
When Cher sang “If I could turn back time…” she might How can this be done in investment markets where well have been lamenting an earlier investment decision. uncertainty and risk are ever-present companions? If so, she probably fell into another trap that our mind By setting out a financial strategy which focuses on likes to play when we invest. When faced with a poor understanding each client’s unique financial goals. These investment outcome the human mind will often try to tell tend to range from the essentials with which our lives are the user that, in retrospect, it is obvious why this would be not complete such as daily living costs, health care and a bad investment. In reality, there are often good reasons visiting children or grandchildren, through to the “would why investors are attracted to bad investments. Even a love to if we could afford it” goals. Such a financial strategy good investment can experience periods of poor returns. does not remove the uncertainty of global investment Psychologists attribute hindsight bias to our brains trying markets but instead ensures a client’s plans are structured to learn how not to make the same mistake again. In order so that they have sufficient capital to meet their essential to do this we trick ourselves into believing that we should lifestyle goals through low risk, stable investment solutions. We have found that when clients know that their essential goals (which the strongest emotions are Having a brain which is programmed to tell you it was associated with) are taken care of, clients are able to obvious in hindsight leads to all kinds of poor future breathe easier. This means that no matter what type of investment decisions. As investment professionals like to investment environment they find themselves in they are say, “Hindsight Harry” might have the perfect investment more able to make thoughtful, open-minded decisions track-record but he is no help with what to do for about how to invest the remainder of their capital. This in turn enables them to make better investment decisions, stick with a programme and ultimately achieve a more Hindsight bias will not stop us getting caught up in the rewarding outcome than if they had tried to think it next Asian crisis, dot-com bubble, global credit crunch or housing market slump. It will just make us feel like we should have known better.
Structuring financial plans and managing clients’ capital in a way that prevents emotionally charged – and potentially So we are fallible. No surprise there. A true cynic could irrational – decisions not only ensures clients feel better say that framing bias leads to investment bubbles and about their financial plans, it also leads to better financial hindsight bias prevents us from learning from them.
disclaimer: this document has been provided for information purposes only. the content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
the views expressed in this document are those of new zealand funds management limited as at the date of this document and are based on information and sources believed but not warranted to be correct. while the information provided in this document is stated accurately to the best of our knowledge and belief, new zealand funds management limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed in this document, except as required by law.

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