In our previous discussion about loss aversion, we looked at what was the beginning of Kahneman's prospect theory. Coupled with loss aversion, narrow framing represents a look at how investors perceive their chances at wealth but only when they see it as the sole component. This is a discussion about risk. More importantly, a discussion about regret.
When you (or as you are often referred to when being discussed by economic types, an agent) moves into the stock market, be it through individual ownership or through mutual funds, you are changing your wealth allocation. Obviously, the easiest measure of wealth is more tangible elements such as what you get paid (human capital) which also includes what you may have saved (not invested) and the worth of your real assets, such as your home. Once you commit a certain portion of either of those two assets to the investment of your choice, you begin to open the door to regret.
This regret is the result of accessibility and the misuse of the different decision rule. Accessibility is what it is: information that is readily available almost instantaneously through any number of mediums and the ability to enter into the market without restrictions. The different decision rule is described in Walter L. Wallace's book "Principles of Scientific Sociology": [the agent]"chooses whichever means optimizes the end in question". This thinking is looking for what could be crudely referred to as the most bang for the buck. Freud called this the pleasure principle.
Narrow framing demands a high equity return both now and in the future. Does this take into account market shifts, both up and down? Not really nor is a realistic approach in the long-term. But loss aversion and narrow framing are not separate thinking.
One of the most famous examples was described by Paul Samuelson, a noted economist, Nobel Prize winner and the person who bridged theoretical and applied economics. When he offered to flip a coin, the prize being $200 if the flip went his colleagues way of loss $100 if the flip went Samuelson's direction, the colleague declined on both accounts. This is loss aversion. When the perception that the loss is greater than the possibility of winning, the investor tends to freeze.
The different decision rule is often described as a way to optimize the end so as not compromise or to incur the minimum amount of cost. Luigi Guiso of the Einaudi Institute for Economics and Finance Via Due Macelli in Rome tested narrow framing using the lottery question, much like Samuelson's coin flip. What he discovered was that if you allow the subject of the test to have time to think about their personal economic and financial situation before you asked them whether they would like to win twice as much as they might lose, they were more apt to attempt to try the game of chance. He wrote: "attitudes towards regret and reliance on intuition rather than reasoning are likely to drive the tendency to frame choices narrowly."
In their book "The Routines of Decision Making" By Tilmann Betsch and Susanne Haberstroh, the authors suggest that the more routine a decision is - such as investing for retirement - the more likely a person was to resist forecasting. In other words, even if the recent economic downturn had been forecasted, and in some instances it was, the person who might be most at risk of losing value in their 401(k) because of out-sized risk or an overabundant share of their portfolio in their company's stock, might have ignored what was obviously a warning. The markets had routinely ascended along with the value of the portfolio and they had seen this as a reoccurring event that probably would not end in the foreseeable future.
This problem is best manifested in the doctor's office. Your physician gives you news about your health that you are skeptical about or might be life-altering depending on your decision. How do you decide how many second or third opinions you garner to help you decide? Suppose those decisions don't jive with how you are feeling?
Next up: Anchoring