The Effect of Framing on Financial Decision-Making

This is the sixth article in the Behavioral Finance and Macroeconomics series. We will explore the effect that behavior has on markets and the economy as a whole, and how advisors who understand this relationship can work more effectively with their clients. (Access past articles here.)

Previously, we discussed the details of a bias called groupthink. Next we'll discuss framing bias. Framing occurs at both the individual investor decision-making level and at the macroeconomic level. This article focuses on the latter.

Framing bias is the tendency of decision-makers to respond differently to various situations based on the context in which a choice is presented (or framed). Examples include how news is disseminated and presented in text and video; how data is represented in tables and charts; and how figures are illustrated. Framing bias also encompasses a subcategorical phenomenon known as narrow framing, which occurs when people focus too restrictively on one or two aspects of a situation, excluding other crucial aspects, and thereby compromising their decision-making.

A classic example of this bias is participation in retirement saving plans. Historically, employees were given the option of whether they would like to participate in a company's retirement plan; employees needed to make an active, "positive election" to join, for example, the company's 401(k) plan. Today, however, some employers provide automatic enrollment in their retirement plans, which involves the employee being enrolled directly by the employer into the 401(k) plan at a specified contribution rate. In these cases, the employee needs to actively opt out of the plan if he or she doesn't want to participate.

From a macroeconomic perspective, by changing the scenario from "do you want to participate?" to "you will participate unless you choose not to," savings rates skyrocket. In their paper, The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior, Brigitte Madrian and Dennis Shea demonstrated that for one company they studied, the retirement-plan participation rate among new hires increased from 37% before automatic enrollment to 86% after automatic enrollment was introduced. You can see how framing bias can have a significant impact on financial behavior.

The framing phenomenon occurs across many asset classes and can show up during extreme market conditions, such as stock-market bubbles. For example, during the technology stock craze of the late 1990s, the market and its pundits framed tech stocks as the "saviors" of the Y2K problem, and investors bid up these stocks. Once the calendar year 2000 change came and went and the markets realized Y2K wasn’t the much of a problem after all, the markets dropped significantly in March of 2000 and dragged tech stocks down.

The lesson here: "look through" how the markets and media are framing issues and how that leads investors en masse to move in one direction instead of another. Advising to go against the crowd can be difficult. I remember during the tech bubble, I was advising clients not to take seriously the crazy valuations occurring with technology stocks. For several years the markets made me look foolish. But when the bubble finally popped, I was vindicated.

Financial markets don't always reflect financial realities. Investors' beliefs, perceptions, and desires exert a tremendous influence on many instruments and indexes. As a result, it's important that both investors and advisors accurately gauge when macro biases such as framing are occurring.

This is, of course, not easy.

My advice is to openly discuss with clients when you as the advisor observe irrational biases of any kind--not just framing--in the market. Caution: You may be wrong for a long period of time! But in the end, mean reversion is a powerful force and is likely to be your friend once the irrationality passes.

Lastly, framing can be particularly important when assessing risk tolerance; advisors and clients alike need to make sure to develop a shared understanding of what constitutes risk and should decide how much risk is tolerable for a given client.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.