I often say that one of our primary roles as an advisor is to provide context and perspective for clients, allowing us to collaboratively make better decisions.
Behavioral economists have identified narrow framing as the tendency for investors to make decisions without considering the big picture or long-term effect on their portfolio. This behavior can be harmful when it leads to bad decisions, like falling in love with a stock or a market sector that has done particularly well recently. If we observe a particular sector doing well, and conclude we should buy more, the overweight can reduce diversification, and hurt portfolio performance when an inevitable market correction occurs. Similarly, a narrow focus on a single, very risky asset may lead us to reject it from the portfolio, when a small percentage could add valuable diversification over the long term. The benefits of portfolio theory are enormous, but require that we consider the big picture – the whole portfolio.
A recent post on the Rockbridge website includes a link to a Wall Street Journal article discussing some of the pitfalls of narrow framing (http://rockbridgeinvest.com/do-you-suffer-from-narrow-framing/), but this is not a new subject. The author of this article, Shlomo Benartzi, was cited for his previous work by some other famous behavioral economists in a research paper from the late 1990’s. The authors of that paper included Amos Tversky and Daniel Kahneman, the subjects of Michael Lewis’ recent best seller The Undoing Project.
That paper discusses myopic loss aversion, which is the combination of a greater sensitivity to losses than to gains, and a tendency to evaluate outcomes frequently. The authors did an experiment that supported their theory that long-term investors would make better decisions if they looked at their portfolio performance less frequently, like yearly instead of monthly. Looking at short-term results is like narrow framing; it is easy to ignore the big picture and focus on a small piece of data. (If you still think looking at your 401(k) balance every day is a good idea, I can send you a copy of the paper!)
It turns out that being short-sighted and attaching outsized negative emotions to losses (another way to say myopic loss aversion), is not good for long-term investment results.
Behavioral economists have devised several experiments to illustrate how loss aversion affects decisions. One of my favorites is the following two questions:
Research shows that most people in Scenario One will take the sure gain. The chance for additional gain is not worth the risk of the coin toss. On the other hand, when faced with Scenario Two, most people choose to gamble, because the pain of loss is significant, and therefore we tend to justify taking more risk to avoid a loss. Now step back and compare the two scenarios – they are exactly the same, but framed differently. It is irrational, from an economic perspective, to choose a different answer based on how the options are framed, but most of us do.
Behavioral economists depart from traditional economists by acknowledging that humans do not always appear rational. Real people often make decisions that differ from a rational person trying to maximize their economic well-being.
Our role as advisors is to recognize that humans allow emotions to affect decision making. We can then help reframe decisions in ways that lead to better long-term outcomes. Pitfalls we can help investors avoid include:
If we acknowledge the impact of our emotions, and constantly force ourselves to step back far enough to see the big picture, we can expect better long-term investment results.
Other articles filed under Investing
October 22, 2018
Stock Markets For the last quarter, stocks are up except for Emerging Markets, which were close to flat. Domestic stocks are seemingly shrugging off the uncertainties of increasing interest rates, trade wars and tariffs. Year to date, an Emerging Market...
October 16, 2018
Interest rates are rising, and yet you may not be earning much on your cash. As financial markets finally begin to reflect a recovery from the crisis of 2008-09, the brokerage industry is changing the way they handle customers’ cash,...
October 12, 2018
We had several clients this year reach out to ask how bonds were performing in their portfolios. These are great questions, so we created a few items to address what you see in your statements. Some people notice they have...
October 9, 2018
“Give, but give until it hurts.” - Mother Teresa - I don’t think Mother Teresa paid much attention to the tax code, but her quote is unusually prescient for 2018 taxpayers. The changes have made it unlikely to get...
September 20, 2018
How does/and how much does your advisor get paid? Fees matter. It is important to know how much you are paying and the value you receive for that payment. If you're paying 1% or more for only investment management with no...