My latest on Yahoo! : Finance and the Framing Effect
Every day I read financial news that is depressing or euphoric, reinforced by data that seems to nail the argument.
Consider this statement:
“The Indian stock markets have grown 20% in the last year, with earnings growing over 18% on the back of an economy that grew 7%, among the largest growth rates in the world.”
And then, in a piece from a newspaper where the sole editor was in a coma for two years:
“In the last two years, the stock markets have gone nowhere, at nearly the same levels of May 2008. Earnings have stagnated – the earning-per-share (EPS) of the Nifty has moved only 2% in the same period, despite the economy clocking growth rates of 6% or more. A fixed deposit in a bank would have done better.”
Finally, a recent headline:
Different headlines, different conclusions. The pieces make you focus on different times – a year, two years and one month respectively – and demand completely different actions, depending on which one you read. Decisions change depending on the way the argument was “framed”.
Here’s an interesting experiment that demonstrates this cognitive bias known as the Framing Effect. Researchers gathered together a few doctors and divided them into two groups. One was told that if a particular medical procedure was performed, there was a 93% chance that the patient would survive. The other group was told that there was a 7% chance of the patient dying within two years. So should they go ahead with the procedure? Although the figures given to both groups were the same, the way they were framed led to more doctors in the first group supporting the procedure in the second.
Now consider another experiment by Dan Ariely. He made students write down the last two digits of their social security number, and asked them to say whether they would pay that amount, in dollars, for certain items he displayed. Then, when they handed in their sheets, he asked them to write down how much they would pay for each product – a blind auction of sorts.
In a perfectly rational world, the social security number process would have no effect on the bids – that means a student with the last two Social Security Number digits of 15 should not bid any differently, on average, than one with 85. But that’s not how it went. For a cordless keyboard, students with higher digits (80-99) made an average bid of $56, while those with numbers 1-20 bid only $16 on average. Overall, the top 20 percent bid about 300% more than the students with digits in the bottom 20%.
This is a brilliant demonstration of anchoring – another cognitive bias that impacts our thinking. When asked, of course, students dismissed the suggestion that the last two digits of their social security number had anything to do with the bidding. It’s not a bias that we will be aware to being present in ourselves.
Framing and anchoring appear regularly in the investing world. A recent commercial on TV by an insurance provider talks about a product that offers a 170% “guarantee” as much better than the fixed deposit. Now, 170% really means your money plus 70% – the specific plan they advertise requires you to stay invested for 10 years before the “guarantee” kicks in – and 70% over 10 years is equivalent to a quarterly compounded fixed deposit interest of 5.3%, a rate banks would kick themselves in the groin to be able to offer with a straight face. Framing at work, yet again.
Some stocks are now considerably below their 52-week highs – therefore, they should be cheap? Or if ONGC is valued at Rs. 1,000 a share but Suzlon is only Rs. 60 per share, isn’t Suzlon a screaming buy? (Don’t snigger – people actually believe lower-priced stocks are somehow cheaper) Anchoring is part of our thinking, though some of you are probably saying, “Listen, everyone might be stupid, but I’m not that stupid.”
But I am that stupid, every once in a while. I still think the a price of Rs 999 is a lot lower than Rs 1001. I still wonder if I should buy as soon as stocks get battered, and regret not doing so when some of those stocks actually recover. Conveniently, of course, I don’t rejoice when some stocks fall further – a victim of survivorship bias, yet another cognitive bias that is hardwired into us.
Avoiding the framing or anchoring biases entirely is difficult, but a few habits have helped me over the years. On the basis of those, I have some tips to offer:
Actively search for opposite views. It’s likely someone else has a different idea about a great investment opportunity I have been presented with, and even if I may not agree, just reading an opposing view helps.
Do your own research. It’s unlikely that what I have been told reveals all the necessary details, so even a cursory search tends to throw up startling facts– facts that can help tone down the euphoria associated with finding what seems to be a pot of gold.
Delay decisions. Sometimes the feeling of having missed the bus makes me want to hurry, but this is one bazaar where there will always be bargains, and there will always be opportunities. I suspect the motives of anyone who requires a decision immediately, such as a broker pushing a particular house at a seemingly fantastic price.
You will be wrong, ever so often. The sin, says legendary investor George Soros, is not in being wrong, it’s in remaining wrong. It’s by making mistakes that I learn the impact of framing or anchoring, so making mistakes is okay.
Embrace uncertainty. So things aren’t going as expected — but that’s the charm of the game we call life. Why should it be any different for the investing world?
This was recently highlighted in a song by Indian Ocean, whose music mesmerizes me. The lyrics of “Darte Ho”, a song not yet released, written by NM Rashid has this to offer:
“Ankahi se darte ho,
Jo abhi naheen aayi,
us ghadi se darte ho Us ghadi ke aane ki aagahi se darte ho”
(You’re afraid of the unforeseen/ You’re afraid of the time that hasn’t yet come/ You’re even scared of the prediction of such a time.)
It’s time to go. The markets are up 1% and I’m sure I need to do something.