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MAKING CENTS OUT OF THE NEWS
Blog #32
(August 20th, 2009)
NARROW FRAMING IS BAD FOR PEOPLE AND PORTFOLIOS
By Tom McAllister, CFP®
Specialists in the new field of "behavioral finance" caution investors to avoid the behaviors and nonproductive thought processes that have proven to be so costly during and after the recent market meltdown. In last week's blog post I talked about the overconfidence that causes investors to trade too frequently and to take too much investment risk, naming that "high horse thinking."
A second very common error pointed out by behavioral finance psychologist is called “narrow framing;” which involves looking at specific investment moves in isolation from one’s entire portfolio. Professional financial advisors always think in terms of a portfolio as opposed to any one investment, knowing that it is impossible to design a portfolio that is certain to have no "losers". We advisers diversify our clients’ portfolios, spreading the capital among many different investments. While some risk is impossible to avoid, diversification reduces risk.
"Narrow framing" can take the form of selecting investments without considering one's own circumstances. Professional advisers always keep clients' individual circumstances in mind; age, net worth, income, period of life, obligations - all enter into account in designing a portfolio to allow clients to meet their life goals.
Israeli psychologist Dr. David Kahneman, winner of the 2002 Nobel Prize for his work in behavioral finance, urges investors to "take a very broad view." Kahneman recommends beginning with strategic decisions based on how safe investors want to feel, then selecting an asset allocation mix that is comfortable given their own circumstances. He urges investors to avoid spending time guessing what a particular stock might do, or fixating on particular economic indicators or industry trends. I am in total agreement with Kahneman's view!
Remember this: “Mistakes” in selecting individual securities are not an unexpected consequence of owning an investment portfolio - they are inevitable! Investors, or their professional investment managers acting for them, must periodically “weed the garden,” removing investments which are not living up to expectations or which have reached unjustifiable price levels. Investors' tendency is to do just the opposite, selling their winners while holding on to their losers, unwilling to “take a loss.” (Of course, these losses already exist!) Recognizing which elements in the portfolio are under-producing and replacing those with better opportunities is what professional investment managers get paid to do.
Dr. Kahneman points out a fascinating psychological aspect to what I call "portfolio weeding." When we sell an investment for a profit, we feel good about it. We “pat ourselves on the back.” In contrast, when we sell an investment for a loss, we accept "immediate punishment” for having made a poor choice - or for allowing our investment adviser to do so! It is not at all surprising that we humans would rather reward ourselves than punish ourselves. History, however, suggests that this very understandable behavior is really very bad for our portfolio health.
We would do much better with counter-intuitive behavior - selling our losers and hanging on to our winners. Behavioral finance thus demonstrates how “normal” behavior can lead to bad outcomes, while trained behaviors can have a more positive effect.
"Narrow framing" can also, Kahneman explains, apply to the tendency of investors to ask the wrong questions. When investors inquire when a certain stock or a certain fund or a certain industry "is a good investment", they're neglecting to give their advisors or potential advisors the necessary details about their specific situation, what risks they are already carrying, their status in life, etc.. This often happens to me on the cruise ships. "What do you think about gold?" "Is this the right time to be in bonds?" "What percentage of a portfolio should be invested overseas?" I resist answering such out-of-context questions about investments until I know more about the investor asking the question!
Hard as it may be, try to avoid "High horse" thinking and "Narrow framing" - you have too much to lose!
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