The biases that we’ve covered thus far have a profound impact on our financial decision making process. However, I’m willing to guess that framing bias and anchoring bias are the two biases that appear most often in our daily lives. I might be biased, because I’m writing this one, but I’ll let you decide after reading this blog. I know what you’re thinking… I probably shouldn’t have biases when writing a blog about…well, biases. That’s the fun of it though, isn’t it? I digress.
Framing bias is when our decisions are impacted by the way information is presented to us. Let’s look at a couple examples to help us better understand framing bias.
Example 1) Which would you choose?
I would select scenario 2, as I’m guessing most of you would. The reality is that these scenarios are identical. The words ‘lost’ or ‘loss’ tend to impact or ‘frame’ our decision making when it comes to personal finance. We will explain in greater detail next week when we discuss loss aversion.
Example 2) 401(k) auto enrollment
Richard Thaler, winner of a Nobel Prize in Economics, helped change the way many employees enroll in their company provided retirement plans. Prior to 2006, most employees had to select if they wanted to participate in their company provided retirement plan. As you can imagine, many employees chose not to, because it was framed to them as an ‘option’. With Thaler’s research, many employers are now encouraged to automatically enroll employees in their company retirement plan with an opt out option. According to a study done by Vanguard, the participation rate of companies that have auto enrollment for employees is 83% compared to 52% if a company chooses to let employees opt in. How we frame options can certainly sway our audience in one direction over another.
Side note: Richard Thaler wrote one of my favorite books of all time, Nudge: Improving Decisions about Health, Wealth, and Happiness. I highly recommend reading this.
Example 3) You join the revolt against hedge funds
You have been reading about the short squeeze revolt against hedge funds that retail investors have been participating in. Retail investors have been purchasing stocks like GameStop (GME) on the thought of making hedge funds lose millions of dollars. You have been in agreement with this philosophy so you decide to purchase several hundred shares.
Regardless of how the stock performs for the remaining duration of your holding period, you have now ‘framed’ your decision making. Your decision is not based on the company’s fundamentals or long term growth perspectives, but rather on the idea that you are taking down Wall Street.
Framing bias can lead you to focus on incorrect information to base your decision off of. An example of this would be an individual selling investments within their portfolio because the holdings are showing an unrealized loss. The investors framing bias is only taking into account unrealized losses, rather than paying attention to the fundamentals of the investment. This type of decision making reduces the amount of information we take in leading to ignorant investment transactions.
It’s very difficult to avoid framing bias in our modern day. Awareness of this bias is the first step to a more rational decision.
Anchoring bias has us rely on the earliest information that we are provided, and therefore making it very difficult to skew from our original belief.
Example 1) Dateline (this is dedicated to my mother-in-law, Teresa)
Most crime shows typically present you with the idea that the person closest to the victim is the one who committed the crime. The first half of the episode is always dedicated to building up the evidence against that person. But, just before the commercial break 30 minutes in, you will be introduced to a new character. The rest of the episode is spent building up the belief that this new person actually did it. So who did it? You want to believe it was this newly introduced person, but the reality is that you are still ‘anchored’ to the person closest to the victim because this thought was your first introduction to the case. It’s hard to sway from your original belief.
Example 2) Investing in a new portfolio based on past performance
You are interested in investing in a new portfolio of exchange traded funds (ETFs). You want to review various aspects of this portfolio including past performance. Historically, said portfolio has returned 10% over the most recent 3 year period. You anchor your decision solely on past performance, and expect this return every year. As we like to say (and 100% accurate), past performance is not indicative of future returns. By anchoring to past performance, you are not taking into account growth perspectives and other important fundamentals within the portfolio.
Example 3) You participate in the short squeeze of hedge funds based on your first interaction
One of your favorite politicians has been vocal about supporting the retail ‘short squeeze’ of Wall Street. The thought is that it has been Wall Street playing with our money this entire time, and now it’s time to stick it to them. This thought was the very first piece of information you saw regarding the recent performance of GameStop (GME), and you agree, so you invest thousands of dollars in the company based on this ‘anchoring’ belief.
Let’s say the stock later declines in value, then you will be faced with a decision that could skew you from your original anchor (and maybe that’s a good thing). If your initial buy in was to stick it to Wall Street, then what’s your reasoning for selling? Your anchoring belief can hold a lot of weight. It may then get in the way of looking past your first initial step (purchasing GameStop) to know what you will do when it comes time to sell.
Example 4) You are in the market for a new Toyota RAV4
You’ve been thinking about buying a new vehicle for a while now. You need something with all-wheel drive for your camping adventures, room for your new baby, and a vehicle that is environmentally friendly. You’ve decided on a new Toyota RAV4 hybrid. One COVID morning, you are researching the cost online and see that on average it should be about $35,000. One week later, you take the next step and visit the dealership, only to be told that the same vehicle you saw online is discounted for $30,000. Now, in your mind this is a deal! You’ve now anchored your decision based on the price you originally found online.
Call it good research or negotiating a deal, however you look at it, it can be defined as the anchoring bias.
Anchoring bias can lead to us filtering any new information presented. It creates the habit of reverting back to our initial view or ‘anchor’ no matter what the evidence suggests. It can create a skewed perspective and make us stubborn in our ways. It can cause us to anchor to a set value and make us unhappy if we don’t achieve a certain number for example, “I want to have $5 million when I retire,” “I want to make $300,000,” “I won’t be happy until we’re saving 20% of our income.” Let’s all strive to be open to other possibilities and give equal weight when necessary.
Anchoring bias is found in all of us. What helped me overcome it? Leaving the city I grew up in for over 25 years and getting a different perspective on life. I’m not suggesting you do that, but I’m suggesting you learn to become comfortable with being uncomfortable. It’s the best way to grow, and if we are held down by our ‘anchors’ we simply cannot do it.
Disclaimer: This article is for informational purposes only and is not a recommendation of Fyooz Financial Planning, Natalie Slagle CFP®, or Daniel Slagle CFP®. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment or financial planning strategy. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.