The Narrow Framer can only see some of the trees
What the novice investor (and many other investors as well) have trouble with is Broad Framing an investment as part of a complete portfolio and as part of a long term investment strategy – that is, they have trouble taking the broad and the long view. The novice investor will frame the investment in the stock narrowly and look at the performance of that one stock and the one stock 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.
Central to Daniel Kahneman’s (psychologist and Nobel Laureate in economics) work has been the issue of how humans make decisions. One of his areas of study has been of Framing effects and the large changes of preference that are sometimes caused by seemingly inconsequential variations in the wording of a choice problem. Let me give you a couple of examples used by Kahneman and then discuss more generally how it comes up in investing.
You have a 10% chance of dying
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, Thinking, Fast and Slow. 2011) p.88.
We see this every day in quarterly and annual reports and of course in the press and on TV. We read in the company’s press release: “Sales are up 15%”. But, you have to read the whole release to see that margins are slipping and net earnings are down. Management is using Framing to convince us the company is doing well.
Framing is also used by politicians, public interest groups and news reporters to put a particular spin on the news. In fact ‘spin’ is another word used to describe Framing.
If I decide that management are using Framing of technically accurate information to bias my thinking about the company, I am not interested in being a shareholder.
Let’s turn now to Framing and the investment process.
We’ve seen that other people can Frame how they present information to us. But, we can Frame how we look at information.
Kahneman points out that experienced traders live by the market, “shielding themselves from the pain of losses by Broad Framing.” (Kahneman, 2011) p.339. What he means is that experienced traders who regularly lose on trades while winning on enough to make good money, Broadly Frame the losses. He could just as well have said that long term investors, like Warren Buffett, do the same thing. Remarkably, Broad Framing acts as a shield from pain!
What is heartening for investors is that Humans can learn to Frame Broadly. Kahneman relates, “we now know that experimental subjects could be almost cured of their Loss Aversion (in a particular context) by inducing them to ‘think like a trader’…” (Kahneman, 2011) p.339. I would rephrase this to read: ‘think like a long term investor’.
Kaheman’s reference to ‘experienced traders,’ who Frame Broadly, is somewhat ironic. For investors (as opposed to traders), the vice of Narrow Framing and thus short term thinking leads to too much trading. The Broad Framing investor, like Warren Buffett, has a favorite holding period of ‘forever’. They are not traders.
Investors can learn all of this by simply reading about Framing, Narrow Framing, Broad Framing and Reframing and thinking about it and then applying it in real life investing – learning and practicing. Another way of understanding Narrow Framing is to think of the metaphor that one cannot see the forest for the trees. The Narrow Framer can only see some of the trees. If you are focused only on the trees, Reframe to a broad perspective. The Broad Framer can see the whole forest. The Broad Framer keeps things in perspective. Framing is both context and perspective.
Keeping the news in perspective
To counter the welter of daily news investors must Frame events broadly and think long term. Trading too often can come about if an investor is too 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.
Framing and diversification
You can Frame over a long time frame or you can Frame a large number of simultaneous events. With very limited exceptions (related to sensible bet size), it makes no difference if one makes a gamble on 100 throws of a coin sequentially or simultaneously.
Imagine a game in which we weight the coin 52% heads and 48% tails, that is, heads are guaranteed to come up 52% of the time. I will pay you $1,000 if you flip heads and you pay me $1,000 if it comes up tails. The odds are that you will win. Would it make any difference to you if you could only play a single throw? What if the game had to be exactly 100 throws? What if the stake were $100,000 for a single throw?
The simple fact is that the chances of winning and losing do not change one iota between a single toss of the coin and one hundred tosses of a coin. What is different between the different games is the Framing. In the case of a single toss game, the subject’s Framing is very narrow: their perspective is of a single bet with a potential loss and a potential gain. With the one hundred bet game the law of large numbers kicks in and the Framing is very broad and you can calmly and rationally view the 100 bets as a whole. With Broad Framing the natural human tendency to risk aversion is neutralized and we are neither risk averse nor risk seeking – we are simple rational. We show risk sense.
The $100,000 wager on a single throw is the most interesting game. If in a lifetime you are only allowed to invest in one stock and then with all your savings, you wouldn’t do it no matter how wonderful the company was or what the odds in your favour were. That’s because you could lose everything. That would be like $100,000 on a single toss game. But, investing isn’t like that. There is a never-ending stream of companies to invest in and you can choose how much to invest in each. Investing is not a single toss game. It isn’t even a 100 toss game. It’s hundreds of tosses with some tosses simultaneous (the number of stocks in the portfolio at one time) and some sequential (the evolution of the portfolio over decades).
Losses in some of the stocks you invest in are to be expected. So, like Daniel Kahneman’s traders, investors can “shield… themselves from the pain of losses by Broad Framing.”
Thus Broad Framing can also be used in portfolio construction. In Decision Theory, for Broad Framing to work, the bets must be independent. If they are not independent, a series of one hundred bets might in fact be a single bet with a very risky outcome. Broad Framing for a portfolio is having sufficient stocks to mitigate the risks of each individual stock. Placing all one’s investments in the energy sector does not make much sense from a diversification point of view. It also violates the need for independence from Decision Theory. There is a separate chapter in the Motherlode on diversification. In short, Broad Framing is one of the techniques we must learn if we are to be capable of taking a long term view.
Broad Framing is looking at an investment as part of a complete portfolio and as part of a long term investment strategy. It is taking both the broad and the long view. The novice investor will frame the investment in the stock narrowly and look at the performance of that one stock and the one stock 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.
Narrow Framing (a bad thing) and Broad Framing (a good thing) are at the heart of the problem of short term thinking and at the heart of several other behavioral biases. Narrow Framing is not the only behavioral bias at work in short term thinking but it is a good place to start.
To read more deeply on the problem of short term thinking and holding onto losers while selling winners, take a look at Chapter 12. Short Term Thinking and our Flower Garden
Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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