The concept of framing can best be explained via an example… assume you are in a shopping centre, standing outside both David Jones and Myer, and you are looking to buy a TV. David Jones is offering the one you are after for $1000, whilst Myer is offering the same one for $950. However, David Jones is also offering a $50 discount for cash, whilst Myer charges a $50 surcharge for credit cards. All other things being equal, which department store would you buy from? Most people report a preference for David Jones, the store offering a cash discount.
This is bizarre in a way, as both department stores are offering exactly the same deal; a price of $950 for cash or $1000 for credit card. But this preference can be explained in terms of how the question or problem is framed. Humans evaluate outcomes in terms of losses and gains from their current, neutral state, which can be described as a starting point of sorts. So in the David Jones example, it appears your starting point is $1000 and you are then offered a saving of some money, which is a gain or improvement from your starting point. However, in the Myer example, your starting point is $950 and yet, you are faced with a potential increase in price, which is a loss or decline from your starting point.
The psychology behind this relates to the fact that humans treat losses of a given amount far more seriously than gains of an equivalent amount. This phenomenon is explained in greater detail below, as loss aversion is closely related to framing.
So how exactly does framing relate to investing? The best way to answer this is to give you the following, rather well-known example. Assume that the outbreak of a new disease is expected to kill 600 people. Assume also that two alternative programs have been proposed to address the problem.
In the first set of options, Program A will result in 200 people being saved, whereas Program B will result in a one third probability that 600 people will be saved, but two thirds probability that no one will be saved. Roughly 75% of people elect Program A as the preferable one.
Now for a second set of options. Program C will result in the death of 400 people, whereas Program D will result in a one third probability that no one will die, but two thirds probability that 600 people will die. Roughly 75% of people choose Program D as the preferable one.
Isn’t this bizarre when you consider that Program A is the same as Program C, but framed differently, and Program B is the same as Program D, but framed differently. And yet people go with Program A and D!
The reason for this is that when information is framed as a gain, people generally go with the guaranteed option. However, when information is framed as a loss, people generally go with the risky option. The first set of options used the word ‘save’ (framed as a gain), whereas the second set of options used the word ‘die’ (framed as a loss).
And this exact phenomenon is seen in the stock market! When making money on a trade (a gain), people often take the guaranteed option by taking profits and locking in that ‘guaranteed’ gain. However, when losing money on a trade (a loss), most people choose to take the risky option by running losses and holding the stock. And yet, any market expert will tell you that good investors do the exact opposite, which they do… they cut their losses and run their profits! Consider what your portfolio will look like if you sell all profits and hold all losses… as mentioned earlier, you will end up, as most junk collectors do, with a portfolio of rubbish.
So try to bear in mind that on account of the phenomenon of framing, your instincts are pushing you to take your profits and run your losses. Do your best not to succumb to this, as cutting losses and running profits is a far wiser course of action.