Investors defending against management spin and ourselves

Behavioral biases

Framing and how we look at things

If you don’t know what framing is, it’s a wonder you survived this long. Daniel Kahneman explains it this way: “Different ways of presenting the same information often evoke different emotions. The statement that ‘the odds of survival one month after surgery are 90%’ is more reassuring than the equivalent statement that ‘mortality within one month of surgery is 10%.’ Similarly, cold cuts described as ‘90% fat-free’ are more attractive than when they are described as ‘10% fat.’ The equivalence of the alternative formulations is transparent, but an individual normally see only one formulation and what she sees is all there is.” (Kahneman, 2011)p.88. (emphasis added)

As investors we see this every day in quarterly and annual reports and of course in the press, on TV and on our devices. We read in the company’s press release: “Sales are up 15%”. But, you have to read much lower down to see that margins are slipping and net earnings are down. Management is using framing to convince us the company is doing well. It’s much more than simply the abuse of reporting adjusted earnings. As Kahneman puts it, ‘what you see is all there is’. The thoughtful investor will be alert to the need to look through the framing effects. The framing effects operate initially automatically in our brains. The investor needs to ensure they are examined, consciously, if this can be done. Instinctively we know we are exposed to framing all the time. It is only when we understand what it is that we can recognize it for what it is. I will call this negative connotation ‘misframing’, as in putting a real spin on things.

We can defend against misframing when others use it against us. But, as important, we can learn to be alert to our own lack of perspective and reframe our own view of things to our advantage.

Let me give you some examples:

Overreaction to new information or dramatic events

Humans have a natural tendency to overreact to important new information or dramatic events. With experience, investors will learn that Mr. Market often goes overboard in his reaction to the news, both good and bad. The phenomenon is what Daniel Kahneman calls the Availability Heuristic. As investors we need to view the news or events broadly. Another way of putting it is to say we need to put things in perspective. If we are able to do this we will have an advantage over poor old Mr. Market.

In this context, framing is the same thought process as thinking about whether the cold cuts are ‘10% fat’ or ‘90%’ fat free. Are we a victim of misframing? Should we look at things differently by changing our perspective? Should we reframe? Should we frame more broadly?

We might ask, does Warren Buffett looks at the world through rose colored glasses? Is he a victim of optimistic overconfidence? I am inclined to think that when pundits are constantly blasting our screens with the horror of our current uncertain times, Buffett is broad framing about the days that lie ahead.

Misplaced confidence in written material containing opinions

It is amazing how much trust we place in well-presented written articles and reports. There is an assumption that published articles and reports are authoritative. To the extent the written material presents facts, information and data one might accept the raw facts. Although, even the presentation of the facts can be biased. We are blinded by Kahneman’s ‘what you see is all there is’. We must always be on guard for framing and spin even with a simple table of data.

What many investors fail to recognize is the extent to which opinions in the written pieces are based on assumptions (not stated) and biases that may or not be valid and on estimates, projections and predictions about the future. Predictions are unreliable, especially about the future! When we read a report on a company we need a learned instinct that constantly asks: What is the hard evidence that supports the opinion; and, what assumptions are being made and what conclusions are based on predictions? And most importantly, what biases and misframing are built into this presentation?

Chart crime

Much as charts can be invaluable for visualizing data, they can, like statistics, be very misleading. Whether wittingly or unwittingly, a chart can frame how we look at the visualization of the data. Framing by the chart creator can lead us astray. If the y-scale doesn’t begin at zero, is there a good reason? Does this give a misleading impression of variability of the y-data? For example, if the y-scale showing price begins at $20 and ends at $25 dollars this emphasizes volatility. One of the most common errors with the use of stock charts is the failure to use semi-log plotting on the y-axis. I have seen a Nobel Prize winner do this. This is no place to get into all the details of chart crimes. Books like Albert Cairo’s ‘How charts lie’ warn and will forearm you. The main message is to be alert for spin and misframing.

Statistics crimes

The well-known quote is “There are three kinds of lies: lies, damned lies, and statistics.” It was made famous by Mark Twain but its real origin is unknown. To learn about the dark art of lying with statistics one can read Charles Wheelan’s ‘Naked Statistics’. Statistics is fertile ground for misframing. The antidote to much statistics crime is to reframe.

Coming to grips with our own humanity

Since humans are pretty pitiful at keeping things in perspective, reframing is a hugely important technique we can all apply to overcome a number of behavioral biases.

Long term thinking vs short term thinking

The novice investor will frame their investments in stocks narrowly and look at the performance of each stock and each stock only and in a short time frame – say in the next days, weeks or few months. A broad framing investor like Warren Buffett will look at the performance of the investment as part of the overall portfolio and over the long haul.

And what of the long haul. What is your investment horizon? Short term or long term. What is you frame of reference? Stocks expose you to serious short term volatility. But, over the long haul and well diversified stock portfolio will beat all other asset classes.

Trading too often

Trading too often can come about if an investor is caught up in the news of the day – as in, what do we read in the tea leaves of the Federal Reserve’s latest pronouncement? Broadly Framed, the latest news is kept in perspective. In the greater scheme of things it may be of no great consequence. The best reaction at most times is to do nothing.

Selling winners

Any behavioral bias that causes an investor to sell too soon is bad. Kahneman notes that: “…finance research has documented a massive preference for selling winners rather than losers – a bias that has been given an opaque label: the disposition effect.”

He says that the disposition effect is an example of narrow framing. “The investor has set up an account [mental account] for each share that she bought, and she wants to close every account as a gain. A rational agent would have a comprehensive view of the portfolio and sell the stock that is least likely to do well in the future, without considering whether it is a winner or a loser [pricewise].” (Kahneman, 2011)p.344.

Holding onto losers

A fan buys expensive tickets to a basketball game. They will have to drive to the game in a nearby town. Another fan is given a pair of tickets. Game day a huge snowstorm occurs. Mental accounting explains why the fan who paid is more likely to brave the blizzard. Kahneman writes: “For Humans, mental accounts are a form of narrow framing; they keep things under control and manageable by a finite mind.” He adds: “An Econ would realize that the ticket has already been paid for and cannot be returned. Its cost is ‘sunk’ and the Econ would not care whether he had bought the ticket to the game of got it from a friend (if Econs have friends).” (Kahneman, 2011)p.343. Most people would be more willing to brave the blizzard when they have paid for the ticket. That is, they will be risk seeking where they have a Sunk Cost. How does this apply to stocks?

Investors know that the price we paid for a stock that now has serious paper losses, weighs on our minds. Price paid is a Reference Point. The time and effort we have devoted to the stock also becomes a Sunk Cost. We should know that the right response in a situation of serious paper losses is to change the Reference Point to intrinsic value. That is, it is time to carry out a Broad Framing analysis of the situation and make a dispassionate decision on that basis. The combined change of Reference Point and Broad Framing would consider purely the intrinsic value of the stock based on its investment merits in the context of the portfolio as a whole and the long term picture.

Admitting you are wrong

And what if the price of the stock hasn’t declined but the merits of the company have. One of the hardest things to do in investing is admit you were wrong. You have purchased a stock with all your normal due diligence. Eighteen month later the company seems to be going nowhere. Investors buying with a margin of safety are often buying stocks where there is a lot of negative sentiment. However, you have your doubts about this particular stock. Maybe it doesn’t enjoy the business franchise you thought it did. The situation is freighted with emotions. You have doubts about your investing ability. You have regrets about your decision. You keep telling yourself you didn’t make a mistake and that things will turn our fine. It’s difficult to admit you made a mistake. You are suffering from the Sunk Cost Fallacy. As a DIY investor, at least you don’t have to admit your mistake to an investment committee or to a client. Again, it’s time to carry out a Broad Framing analysis of the situation and make a dispassionate decision. You may decide you continue to be right about the company. Perhaps Mr. Market hasn’t caught up with you yet.

Hard time averaging up

Investors seem to have a hard time averaging up. If an investor buys shares and the price goes down modestly, it seems much easier to buy more of the stock. But, if the stock goes up there is a reluctance to buy more. This is probably because the investor will believe the price previously paid is a fair price and that, accordingly, any price above that is overpriced. This is a combined problem of Anchoring, the Endowment effect and Narrow Framing. Of course these are the same behavioral biases and cognitive errors we looked at when prices went down below our cost price. The solution? Reframe to the bigger picture of the portfolio and the long haul and change the Reference Point to intrinsic value.

House money

An inheritance, a windfall or found money is essentially the same problem as gamblers at a casino looking at their winnings as ‘house money’. Gamblers have a propensity to take higher risks with house money than with their original stake. This is a result of Narrow Framing. It leads to risk seeking behavior. Broad Framing is called for.

Conclusions

Framing seems to creep in everywhere. We are exposed to spin doctors framing political events, pundits sensationalizing business developments and company management misframing corporate results. But we also victimize ourselves by not keeping our investments in perspective. Fortunately, as we have seen, there is something we can do about it.

Want to read more about the issues raised in this post, take a look at Part 2: Human Foibles and Investment Decision Making and Chapter 12. Short Term Thinking and our Flower Garden. You might also look at Chapter 13. Overweighting improbable outcomes, Chapter 14. Changing our minds, Chapter 15. Jumping to Conclusions, Chapter 17. Recent events – vivid memories, and finally Chapter 18. Over-confidence and optimism

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