Why Investors Do What They Do: Narrow Framing

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

Why Investors Do What They Do

A recent report done by Dalbar, inc. of Boston suggests that investors often do things that hurt what they are attempting to do in numerous ways. Using information aggregated from the Investment Company Institute (ICI.org, a company that tracks and support the mutual fund industry), The Standard and Poors Company (the standard bearer of indexes) and Barclays (which publishes an index of bonds), the company has found that there are numerous influences, both external and internal, that have an effect on how well a portfolio of mutual funds (or stocks for that matter) perform over the short-term and long-term.

They identify nine areas where investors thought they were right, when they were in fact, ignoring signals that the approach they were taking may have led to, even exacerbated losses rather than gains. The report cites these facts from the study to support these claims:

* For the 20 years ended December 31, 2008, equity, fixed income and asset allocation fund investors had average annual returns of 1.87%, 0.77% and 1.67%, respectively. The inflation rate averaged 2.89% over that same time period.
* Equity fund investors lost 41.6% last year, compared with 37.7% for the S&P 500 Index.
* Bond fund investors lost 11.7% last year, versus a gain of 5.2% for the Barclays Aggregate Bond Index. This disparity is largely due to the underperformance of managed bond funds caused by mortgage-backed securities.
* With an annual loss of 30% last year, asset allocation fund investors fared better than equity fund investors.

The first of these nine areas, which we will examine over the next nine posts, deals with loss aversion. Falling squarely into the realm of behavioral finance, numerous academics have sought to model a realistic estimate of how investors react in certain circumstances, whether those reactions were realistic given those circumstances and how financial decisions are evaluated and eventually made.

While risk and uncertainty have their place in the investment world, how people react under those conditions was the subject of a paper done by noted psychologists Kahneman and Tversky titled the Prospect Theory. They realized that "since loses loom larger than gains, it appears that humans follow conservative strategies when presented with a positively framed dilemma, and risky strategies when presented with negatively-framed ones." They also noted that numerous influences enter into the equation including normal behavior, habits the investor might already have and the personal characteristics of the decision maker.

How you frame the argument (in an investor's mind), even if it is the same problem, directly affects how the investor reacts. Frame it negatively, and the reaction often leads to risk taking; frame it positively and the investor will chose a risk averse solution.

The battle between what "would happen" if a decision is reached is often overshadowed by the repeated decision making based on what has already occurred. Economists refer to this as a continuous process suggesting that an investor might become overconfident and that generates irrationality.

Martin J. Pring once said, "For most of us, the task of beating the market is not difficult, it is the job of beating ourselves that proves to be overwhelming." According to a Stanford University Business School paper published in July of 2006, "the principle of loss aversion is not derived from any theory of behavior or more basic psychological principles, but is an ad hoc principle introduced to account for a range of phenomena involving tradeoffs between losses and gains." In other words, most investors seek the status quo.

And to change the status quo, investors need a motive. What happens if those motives are fuzzy or ill-defined? The paper, written by David Gal cited an experiment done by Kivetz and Simonson which "offered diners a reward program in which they could receive a free meal at a dining hall after having paid for a certain number of meals. In a between subject design, they found that sushi lovers would actually prefer a reward program which required the purchase of 10 sandwiches and 10 sushi platters to a program which required only the purchase of the 10 sandwiches. Although the former option was dominated by the latter, sushi lovers perceived a relative advantage in that they would likely have eaten the sushi anyway. Based on this relative advantage, sushi lovers inferred that they were getting a "bargain" in an absolute sense."

When information is fuzzy though, it is difficult to determine what the status quo actually is. If you were offered a 50% chance of losing $100 or a 50% chance of winning a $100, the trade-off might seem relatively straightforward. The better bet is to not take the bet at all. What is needed although is a clear preference of what the status quo is.

Loss Aversion does exist but it is difficult to define and hard to expect. Studies have shown that historical data (past performance indicators) often lead us to make these decisions and yet, that same historical data may have little to do with what we may gain, or lose.

Next up: Narrow Framing of Investment Decisions

Retiring with a Plan: Is the Roth 401(k) Conversion Worth Trying?

In 2010, you will be allowed to convert not only your current 401(k) plan but your IRAs and any 401(k) plan you might have rolled over into an IRA. The question: is rolling your retirement money into a Roth 410(k)the right move to make?

As with all financial decisions, this takes a little bit of planning and consideration. The conversion will cost you money, mostly in tax dollars paid because your 401(k) plan, IRA or rollover action, saved you from paying on taxes that a Roth 401(k) will require you to pay.

Traditional plans defer those taxes. But once you opt for the Roth 401(k) or even a Roth IRA, the taxes on the transferred amount will need to be paid. This is because the money invested in a Roth is done after taxes. The first consideration is whether you will be able to pay those taxes.

A Window Of Opportunity
You do have a window of opportunity though. Taxes due on these types of conversions in 2010 are payable in 2011 and you have two years to pay them. Estimate the taxes on what you have in these accounts based on your ordinary income tax rate. There are no penalties other than this in the conversion. But depending on the size of your account balance, you will need to set aside this amount starting before you make the conversion.

The simplest way to do this is to set aside the money in a separate account - preferably away from your emergency account. (An emergency account is savings set aside for emergencies and if you can have a minimum of three months set aside, you are well ahead of what you neighbor probably has.) On the other hand, this money should not be invested either. This is cash for taxes and has no risk potential. Some of you might be tempted to put it in a taxable indexed mutual fund to get some work out of the cash, but this would not necessarily be the wisest choice.

This is also an opportunity best used for those who are above the current $100,000 a year income threshold. These folks have been unable to save more for their retirement because of this ceiling. Expect this group to do this in droves - if they are smart. For the rest of us, the transition may not be worth it.

Many of us are underinvested as it is. We cannot accurately see what the future tax rate will be on these invested dollars yet we can be assured that we will not have the same tax rate as we do know. If studies are correct, most of us will be in a far lower tax bracket, lower than most of assumed we would be in come retirement.

Keep in mind that if you do exceed the AGI (adjusted gross income) of $100,000 the conversion doesn't necessarily mean that you will be able to contribute more. There is way around this. If you were to make nondeductible contributions to a Traditional IRA and roll them into a Roth IRA in 2010, but only the contributions, not the investment gains, that part of the rollover is not taxable. The gains on those "nondeductible" contributions would however be taxed.

Ultimately a Tax Issue
Phase-outs are linear, meaning what you make determines the level of contribution. Because this is a tax issue and you should always consider speaking with a tax professional first, the following is just a guide to see where you fall in terms of income, phase-outs and contribution levels.

If you are a Single filer, your Roth contribution limit is reduced when your modified AGI or adjusted gross income exceeds $101,000.00, It is eliminated completely when it reaches $116.000.00

A person wishing to determine their contribution status if they are Married Filing Jointly will find their limit is reduced when their modified AGI exceeds $159,000.00 and is eliminated completely when it reaches $169,000.00. When it falls in between those amounts, the linear contribution phases in. For instance, if you were half way between, your contribution would be reduced by 50%.

Another tax filing status might affect your contribution levels differently. A person Married but Filing Separately, (and) Living Apart would find their Roth contribution limit is reduced when the AGI income exceeds $101,000.00. It would be eliminated completely when your modified adjusted gross income reaches $116,000.00

Those choosing the Married Filing Separately, or Other has a limit as well. These folks will find their contribution is reduced when their modified AGI exceeds $0 and is eliminated completely when your modified adjusted gross income reaches $10,000.00.

Once it exceeds those limits, you will not be allowed to contribute.

But as with all financial investments, they are not static. They may in fact be worth less. Because of that, you may want to look into a IRA Recharacterization.