Last month, we discussed framing. This is not necessarily a psychological bias, it’s just the way we make sense of the world. The problem with framing, though, is that most people don’t even know when it’s happening. We might think that we are able to frame decisions in different ways to assist our decision-making, but our decision frames are generally more limited than we’d anticipate them to be. In this article, we will discuss the effect of framing on the investment decisions we make, in particular, the size of our frames.
From an investing point of view, people who frame decisions make narrowly worse investment decisions overall. They tend to view each individual purchase or sale in terms of that transaction only. This is more correctly referred to as ‘narrow framing’. A wider frame would be to view the overall share portfolio or your overall wealth. While this might not seem like it will make much of difference, research shows that it does. Generally, the wider your frame, the more diversified your portfolio will be, but with greater volatility attached thereto.
Linked to this is our good old friend, the disposition effect – that is, the tendency to sell shares that have increased in price and to hold onto those that have decreased. The narrower an investor’s frame, the more likely he or she will exhibit these tendencies. This can be expected if investors are narrowly following their individual investments rather than a wider frame of overall wealth.
Nevertheless, investors with a fixed and tight frame generally think they made all the correct investment decisions. And, from their framed perspective, they usually have. This might be the biggest danger with framing. You won’t know its affect until you step outside your frame.
Yes, it’s common sense to value a company individually when considering a potential investment. Narrow framing isn’t cautioning against this approach. It’s merely saying that you should also consider that potential investment against the rest of your portfolio and your overall wealth in its suitability in your portfolio. Too many defensive stocks? Too many shares and too little property? Debt repayment a better option? Get the idea?
Author: Gizelle Willows CA(SA) MCom Finance is Senior Lecturer in Financial Reporting at the University of Cape Town