What Is Framing Effect? How It Influences Decision Making Process In Investing?
By: Rupesh Oli
What is Framing Effect?
Framing Effect refers to a cognitive bias underlying the context where the people base their decision based on the positive and negative connotations presented over them. When positive and negative aspects of the same decision are conveyed to individuals, the decision or the choices vary as per the relative attractiveness possessed by those particular aspects. Basically, to get a transparent overview, the frames can be disseminated into positives and negatives. When a positive frame prevails, people tend to avoid risk. On the contrary, they tend to seek risks when presented with a negative frame. The positive frame denotes the gain, whereas the negative frame – the loss.
Here the some of the instances reflecting the framing effect.
- Suppose you being a diabetes patient is seeking the consumable products with a minimal percentage of sugar and you found out the products where it is mentioned 85% sugar-free in one of the products and 15% sugar over the other. Due to the prevalence of the framing effect, you tend to select the first product over the second. However, it is to be noted that both the products are trying to convey the same information to the end consumers. The only difference is one tried to convey it positively whereas the other negatively.
- You are hunting for a hand sanitizer. One claimed to kill over 90% of the germs and the other in such a way that only 10% of the germs survive. In such context, you tend to go with the former product than the latter one.
- You are in search of a new disc brake in your bike to replace the previous one. What would you prefer – A disc brake conveying 90% effectiveness or the one expressing the lack of 10% in its effectiveness? You conceive 90% to be more preferable and 10% might discard you from selecting it as it indicated ineffectiveness. Even though both are identical, you fall into the trap of framing effect and select the former disc brake for your bike.
Hence, you react the way choices are framed to you preferring the positive frame and discarding the negative one. The analogous level of impact can be comprehended in the case of investors when they undertake their investment decisions. For instance, suppose, an investor is presented with two scenarios. The first option depicting s/he will be gaining $700 profit over the next 6 months, however, in the end, will only be able to retain $500 of the profit. The second option is that s/he will gain $700 profit over the next 6 months but framed in such a way that s/he will lose $200 of the profit facing the market volatility. The final outcome depicted by both options is profit retention of $500 at the end of 6 months. Investors tend to prefer the first option over the second one because the first option frames the gain instead of loss. Thus, the equivalent information can be perceived as less or more attractive based on the level of gains or loss conveyed to the end audiences.
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Types of Framing Effect
Levin et. al. (1998) have come various types of framing effects in their research paper illustrated below.
| Framing Effect | Example |
| Risky Choice Framing | The opportunity to save 90 out of 100 lives vs the risk of losing 10 out of 100 lives. |
| Goal Framing | Motivating people by offering a $5 reward vs imposing a $5 penalty |
| Attribute Framing | Beef with composition being 95% lean vs 5% fat |
What Causes the Framing Effect to Evoke?
The framing effect is a cause of human perception as we perceive the context surrounding us in such a way that we overweigh the positive aspect and shun the negatives. Amos Tversky and Daniel Kahneman – the two greats in the domain of psychology – considered framing effect as a part of Prospect Theory as we consider loss more significant worthy of avoiding and embracing the equivalent gain, instead. The way the framing effect evoke depends on how we emphasize and what sort of reference points are we susceptible towards? Further, we fall prey to heuristics as our minds prefer shortcuts rather than evaluating and processing the underlying information. We often neglect the long-term consequences of the decision we undertook and do not emphasize enough time and effort to analyze what can go wrong before taking such decisions. Therefore, perception and heuristics can be considered as the primary causes of the framing effect.
How Framing Effect Influences Decision Making Process in Investing?
- Investors tend to react to the investment opportunity based on its portrayal of framing. They tend to consider it a worthwhile investment option considering whether the association is with gains or losses, although the payoff remains the same. Hence, such decisions remain intact with biases and may lead to a contrary outcome in regard to the expectations of such investors.
- When the negative frame is portrayed to investors, they tend to seek risks. On the contrary, investors tend to avoid risks when they are conveyed with a positive frame.
- When investors decide to invest in a particular company, they might be neglecting the fact that the potential company could glorify its positive aspects than what needs to be actually depicted and they too might deliberately put forth the competitor’s negatives in order to elevate their own company. As a result, an investor might fall into such a trap facing consequences in terms of financial losses.
- Reyna and Farley (2006) argued that the framing effect increases along with the age. Hence, older investors might be possibly dealing with the framing effect a lot than the younger investors. It is because qualitative reasoning increases with age rather than quantitative reasoning. While the younger investors rely more often on quantitative reasoning, they might be approaching towards worthwhile investment. On the other hand, the old investor can be victimized by the framing effect as they strongly rely upon qualitative reasoning.
- Candraningrat et al. (2018) argued that the framing effect plays a part in surging and diminishing the stock prices. It is because the company conveying positive information (the positive frame) to the investors is perceived as the company with less investment risk, hence leading to the acquisition of a high number of investors increasing the stock prices. On the contrary, companies lacking to impact investors or portraying the negative frame are likely to be perceived as the investment of high risk hence leading to a high number of sellers selling the stock of that particular company ultimately decreasing the stock price.
- If an investor gains profit in previous trades, it can be referred to as a positive frame of reference. On the other hand, a negative frame of reference can be undertaken as the context in which an investor faces loss in the previous trade. If they are to consider their previous execution of a trade as a sequential activity, their previous investment decisions hamper the upcoming decisions as well. However, for any rational investor, framing shouldn’t have any major impact. It is to be noted that investors are not completely rational thereby leading them to fall prey to the framing effect.
- Investors, despite being aware of the fact that stocks do dip down for correction to hit another high in the market, often sell their stocks when the market drops. They ignore the fact that buying high and selling low, is one of the possible worst investment decisions that you could undertake.
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Significance of Framing Effect
Although possesses many adverse impacts, yet, the framing effect is considered to be one of the significant cognitive biases – significance in terms of overvaluing or undervaluing our investment decisions. Based on how the investment options are framed to us, we can deviate in between the best and worst possible options. Often, a company sheds a positive light on its loopholes and drawbacks misguiding the investors. Hence, it is necessary to analyze the perspective a company trying to communicate to its probable investors through both the positive and negative aspects so that one could delve towards a rational decision. Not only in investing, but we also need to analyze framing effects on our personal lives and day-to-day decision-making.
How to Overcome Framing Effect?
- If individuals posit the tendency of carefully analyzing their choices and decisions, the framing effect would be mitigated or eliminated to a certain extent.
- Individuals need to examine the information accessible to them, in such a way that they come up with the relevant ones that could be more effective in their decisions.
- Detailed mental processing is significant before selecting an option or relying on certain information as it pushes us to become more rational towards our decision.
- Investors need to be vigilant about the data presented to them analyzing the possible extent to which that particular data can be framed. If done so, s/he can filter out between the actual and gimmicky set of data leveraging them to take an unbiased and informed decision.
- Rather than focusing on unrealistic gains and losses, investors ought to take the real perspective towards possible gains and losses. Doing so will help them be less susceptible to the framing effect and have a viewpoint towards the practical aspect of investing.
- It’s better you avoid impulsive and reflexive decisions, instead, try to adopt the logical and reflective approach.
- Investors need to embrace the fact that the framing effect impacts our subconscious, and our minds are trained in such a way that we make our decisions subconsciously.
- Before delving towards any sort of decision, you need to acquire a wide range of information from a broad array of sources focusing on critical evaluations rather than driving away with the emotional decision making.
- You need to examine the advertisements thrown at you and analyze the raw details instead of being fully blown away by the unrealistic and over-the-top advertisements.
- Try to challenge the frame presented to you by thinking rationally and outside the box. For instance, if you are dealing with the same sort of problem consistently, instead of trying it eradicating forcefully, you might solve it with a different approach of framing. For instance, instead of trying to speed up a particular task, you can try out the possible ways to complete that particular task making it more enjoyable. Hence, reframing through alternative possibilities of underlying circumstances might provide you with a new perspective to deal with it.
Conclusion
To conclude, the framing effect is one of the common biases that not only an investor, but people of every background possess. Whether you call it impacting your decisions with your natural instinct or lack of critical evaluations, it prevails. Hence, the sound expertise of framing effect and the potential impact it carries is vital so that we could take our decision rationally. Along with it, insights on its possible causes and some of the ways to overcome it would be much more beneficial.
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