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Framing effect: Your perception depends on the frame

February 19, 2019

"Here is a riddle for you to solve." from the series 'The biggest investor mistakes'

Here is a riddle for you to solve. I am going to describe something and you have to guess what it is. So, let's start: A newspaper is better than a magazine. On the shore is a better place than in the street. Initially, it is better to run than to walk. Even small children can have fun doing it. Birds rarely get in your way. A rock can serve as an anchor.

It's all Greek to you? Well, here is the riddle's solution: I was just talking about flying a kite. All of a sudden, everything I said makes perfect sense, doesn't it?

This goes to show: Without context, we are, more often than not, unable to understand things. As far as language is concerned, we constantly put information into a frame or context. Such a frame of reference is vital. But it can also be fatal — if it is flawed.

The cognitive process of putting things into context is what psychologists call “framing”. We all have our very individual experiences, habits, ways of thinking and filters that influence our frames. People whose frames are different tend to misunderstand one another.

Glasses that are half full, vases and sweet fruits

If the weather forecast tells us there is a 20% chance of rain, we cancel our excursion; if it says there is an 80% chance that it will stay dry, we do not—irrespective of the fact that both statements mean exactly the same thing. We can perceive the glass as being half full or as being half empty. And we can interpret that famous ambiguous image as either a vase or two faces looking at each other (see image). It is all a matter of our “frames”.

Advertising psychology also takes advantage of the “framing effect”: An image of sun-ripened, freshly picked oranges makes us think of freshness and sweetness, although the orange juice has been in the carton for months.

High risk and high expected yield

When it comes to finance, the situation is similar. On the one hand, people wet our appetite for “high-yield bonds”, which can earn investors a lot of money. On the other, they warn us of “junk bonds”, which involve considerable risk. Which type of bond would you prefer? Presumably, the former, wouldn't you? However, in view of the fact that in finance high risk is synonymous with potentially high gains, these two terms actually refer to one and the same thing. The only difference between them is this: While “junk bond” stresses the high-risk nature of such investments, “high-yield bond” emphasizes that their return can be expected to be high.

Some years ago, my investment consultant advised me to sell my holdings in a health-care fund, saying that price increases in previous years had resulted in considerable gains that I should now turn into cash. I asked her whether she would also have given me this piece of advice if she had not known the price at which I had acquired my investment. Her answer was: No. She went on to point out that I did not have to sell, that the performance of my investment was stable and that there were even more gains to expect in the future. In asking my question, I had used the technique of “reframing”, shifting the frame of reference away from the buying price—and my consultant made a U-turn, advising me to keep rather than sell my investment. Interesting.

Tips

This shows that whenever we make a decision we have to keep its context in mind. For our decisions to be rationally sound and as unbiased as possible, we need to factor different frames into our decision-making.

As far as your investments are concerned, this means: Look behind the frame! Use the technique of reframing! A high-yield bond, for instance, has a high expected yield, but it also involves high risk. Would you also acquire the bond if it were referred to as a “high-risk bond”? Change your point of reference: Adopt a different perspective and see how this affects your decision to buy or sell an investment. Convert foreign-currency investment returns to euro! Convert nominal investment returns to inflation-adjusted returns! Question your own framing and that of other people, such as your investment consultant. Following these tips will help you make your decisions in as unbiased a manner as possible.

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