How Investment Choices Are Framed Determines Our Decisions

TOM HUDSON: Investing involves making choices. Do you invest in this fund or that one? When should you sell? How an investment choice is presented or framed can have a big impact on what we decide to do with our money. So what can you do to keep framing from leading you to making the wrong investment decisions? Tonight, in our “Your Mind and Your Money” series, we’ll discuss that with Dan Ariely. He’s professor of psychology and behavioral economics at Duke University and author of the new book, “The Upside of Irrationality.” Dan, welcome to NIGHTLY BUSINESS REPORT.

DAN ARIELY, PROF., PSYCHOLOGY & BEHAVIORAL ECONOMICS, DUKE UNIV.: Good to be here.

HUDSON: So how do outside forces like framing influence our investment decisions? Can you give us a real life example?

ARIELY: I can give you a few. I can give you 18 actually. Let’s start with one. So often when they give us a particular portfolio, they tell us over how long of a period the calculator returns. Sometimes it could be 10 years, five years, 30 years. It turns out that’s the input that we take and figure out whether this is a good fund or not a good fund, but somebody else decides it for us. This is one example.

HUDSON: I want to talk about time frame in a moment. We’ll have a visual example of that. When you talk about the they, you’re talking about financial service professionals here, mutual fund salesman or whomever, even neighbors for instance. We know that behavior finance buyers are usually concerned about not buying too high or at least not making — not losing money. How does that play in to that kind of marketing?

ARIELY: So part of the interesting thing is that people really hate losing much more than they enjoy gaining. Here is what happens. If you buy a particular financial product, even if you think you’re just going to buy it for a while and see what happens, the moment it goes down, you get attached to it. You don’t want to sell it. You don’t want to realize your losses. Therefore you actually get locked in for much longer than you think you would.

HUDSON: Assuming that is acting irrationally, holding on to a losing investment, how do we break that chain and act more rationally?

ARIELY: One particular advice is to imagine every day or every time that you want to rebalance your portfolio is as if you have everything in cash. So here’s the situation. Usually you buy things and sell things. You’re holding some stuff in your portfolio. When you start thinking about the next period, you start from the perspective of what you’ve been holding so far. If you’re going to sell something that you’ve lost money on, you’ll feel very miserable about it. Now imagine that somebody went into your account every night or every quarter and basically sold everything and left you just with cash. Now all of a sudden you don’t have any particular loss. You don’t have any particular attachment to individual stock. You can decide to allocate from the start.

HUDSON: Let’s talk more about the time frame issue here because this is best illustrated by looking at, for instance, a chart of the S&P 500. When you take a look at that chart from March of 2009 through today, clearly the direction has been very positive if you’ve bought stocks back in 2009. But if you look at it from March of 2000, boy it’s been a choppy ride and a disappointing one for a lot of long-term investors. How should investors approach time frames? Should you disregard them entirely?

ARIELY: This is a very hard question and the SEC is actually struggling with this. Because often when we get advice from financial advisors, they tell us what this period is based on. So the first thing to do is to apply this same kind of time frame to all of your decisions, right? You don’t want to be looking at one decision in a one-year framework and another one with a 10-year framework. You want to look at all of them from a similar perspective. The other thing to realize is that historical gains are just very loose and imprecise indicators of future gains. Don’t rely on them too heavy as well.

HUDSON: Many thanks Dan, my guest tonight, Professor Dan Ariely of Duke University.


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