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:
- Scenario One: You have accumulated $9,000 and face a choice: take $9,500 for sure OR flip a coin, heads you get $10,000 and tails you keep the $9,000 you start with.
- Scenario Two: You have accumulated $10,000 but cannot just keep it. Your choices are: flip a coin, heads you keep $10,000 and tails you keep only $9,000 OR take $9,500 for sure.
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:
- Falling in love with the short-term performance of a particular asset or sector and taking too much risk.
- Being frightened by negative performance and taking too little risk.
- Buying winners and selling losers without considering overall portfolio diversification.
- Focusing on an isolated account without considering its role in the context of your total portfolio. Sometimes this can be minimized by consolidating accounts; for instance, all your old 401(k) accounts can be consolidated in one rollover IRA account at the same custodian that holds your taxable brokerage account. This makes it easier to track overall performance and optimize placement of tax-efficient and inefficient asset.
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.