Framing, Anchoring and Confirming

Framing, Anchoring and Confirming

Published On: August 17, 2020

Written by: Ben Atwater and Matt Malick

Behavioral finance is the crossroads of psychology and economics.  It recognizes that investors are not always rational, have limits to their self-control and have biases that influence their decision-making. 

Readers have been particularly interested in this series.  For your easy reference, we created a landing page for Behavioral Finance on our website.  On this page you will find all the essays in this series.  Please feel free to share it with your friends, family, and business associates. 

In today’s email we are going to examine framing bias, anchoring bias, and confirmation bias.  All three are arguably emotional biases in behavioral finance. 

Framing bias occurs when we decide based on how someone presents information to us, as opposed to simply on the facts themselves. Someone presenting the same facts in two different ways can lead us to make different judgments.

Let us consider someone who invested $1,000,000 five years ago and their portfolio has grown to $2,000,000.  We will now assume the market has a meaningful correction and falls by 20%.  This investor now has a balance of $1,600,000. 

Following this downturn, the investor is far more likely to lament the $400,000 that they recently lost than to appreciate the $600,000 that they earned on their original investment.  This is a case of framing.  Framing tends to have a negative bias because study after study has shown investors find losses more troubling than they find gains satisfying. 

We see this bias linguistically when we hear people refer to their gains using a percentage – “We made 40% on XYZ stock.”  But, in an opposite scenario they might say – “We lost $50,000 on XYZ stock,” referring to their losses in dollar terms.  In other words, we hear percentages on the way up and dollars on the way down.  (Full disclosure:  This is a concept Ben’s Uncle first observed and shared with us, but we see it repeatedly and wholeheartedly agree.)  This phenomenon further shows the emotional pain of losses versus the neutered reaction to gains. 

To a large extent the framing effect has allowed the variable annuity industry to thrive over many decades.  We refer to these investments as false panaceas.  Variable annuity salespeople claim their products offer a guaranteed minimum return and participation in equity gains without the risk of loss.  A close analysis of these claims shows them to be technically true, but highly misleading.  The variable annuity was devised to address framing by telling investors they cannot lose; they can only win. 

Another emotional bias is anchoring bias, which occurs when we rely too much on pre-existing information or on the first information we find when we make decisions.

A great example of anchoring bias from early in our careers is General Electric stock.  In 2000, ironically enough at the height of the dot com boom, General Electric was the largest weighted company in the S&P 500 and the largest company in the world.  These were the halcyon days of GE when CEO Jack Welch was an international celebrity and people widely believed him to be a fabled business legend.  During this time, the stock reached $55 per share. 

After the stock plummeted to $23, there was a tendency among investors to “wait” for the stock to again return to $55 per share before selling their position.  This anchoring bias – the stock was $55 so it will be $55 again – was a substantial mental barrier to investors exiting the stock.  Today with the stock at $6.72, everyone has given up, but in some cases decades too late. 

In 2009, when we started Atwater Malick, many clients wanted to avoid fixed income because they thought interest rates were heading higher (and, therefore, bond prices heading lower).  The ten-year Treasury yield stood at 3.71% as of September 2008.  For many folks, their anchor for interest rates was when they started their first business or purchased their first home in an era when interest rates were well into the double digits.  Since then, Treasury prices have surged while yields have fallen.  The ten-year Treasury stands at 0.64% today.

Confirmation bias is the tendency of people to pay closest attention to information that confirms their beliefs and downplay information contradicting their beliefs. 

One of the hottest stocks this year is electric car maker Tesla.  In our minds, the value of Tesla makes no economic sense whatsoever.  We think its stock price is a form of insanity.  And despite Tesla founder Elon Musk’s obvious brilliance, he is also a bit of a huckster.  To us, positive news about Tesla, like a recently announced stock split, cheery production numbers or new model announcements are largely irrelevant because they can never justify its enormous valuation. 

But, to a Tesla car owner, an Elon Musk fan and a Tesla stockholder, the same positive news we pan, they celebrate.  The information is the same.  However, our feelings are so strong it is truly difficult to process positive Tesla news as validating its market value.  On the other hand, for someone who is a stalwart enthusiast, it is easy to accept the news as further reinforcement of the company’s successes. 

As we like to repeatedly point out in this series, behavioral biases are not always bad.  They can serve a purpose in guiding our decision-making.  They allow us to process information more quickly.  However, it is helpful to be aware of our behavioral tendencies and think about why we are making important decisions. 

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