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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