Framing bias. Your risk appetite is manipulated by how the broker’s questionnaire is worded.
Framing bias refers to the tendency to respond differently based on the context or presentation of a situation. It can affect decision-making in financial markets, including risk profiling questionnaires. Discover whether you are prone to a framing bias and the extent to which it affects your investment decisions with PRAAMS BehaviouRisk.
Behavioural science. What is framing bias?
Framing bias is a behavioural pattern whereby a person responds differently depending on the context of the question, i.e., how the situation is presented.
Framing bias is a cognitive bias, i.e., a mistake in decision-making. These biases can be effectively corrected with education.
What are the consequences and portfolio risks?
Frames are different visual information settings or ways to word a question. Framing bias lies at the heart of many marketing tricks and, sadly, is very frequent in financial markets. A typical example is positive-negative or optimistic-pessimistic framing. Tversky and Kahneman presented the most famous example of such framing in 1981 (Kahneman won a Nobel Prize in 2002).
“Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimate of the consequences is as follows:
Positive frame:
· If Program A is adopted, 200 people will be saved.
· If Program B is adopted, there is 1/3 probability that 600 people will be saved, and 2/3 probability that no people will be saved.
Negative frame:
· If Program C is adopted, 400 people will die.
· If Program D is adopted, there is 1/3 probability that nobody will die and 2/3 probability that 600 people will die.”
All four options are identical in expected numbers: 200 lives will be saved, and 400 will be lost. Despite this, the study showed that with the positive frame, less-risky option A was preferred (72%). However, with the negative frame, a riskier option was selected (78%).
One of the most debatable implications of framing bias in the financial markets is risk tolerance questionnaires many investment firms use to determine clients’ risk profiles and tolerances. Risk tolerance is critical to successful investing, and tampering with it will have grave consequences for investment returns. Stating that ‘this investment gives you a 60% chance of reaching your financial goals’ elicits a much better response than ‘this investment gives a 40% chance of falling short of your financial goals’, even though these options are identical. Another trick is formulating a questionnaire in terms of sizeable losses (‘your portfolio lost 25%, what would you do next?’). Losses, on average, tend to stimulate people to engage in more risk-taking behaviour than the prospective profits warrant. By using these and other tricks, investment firms can ‘lead’ their clients into more risk-aggressive profiles to be able to legally sell them higher-risk trade ideas, which bring them higher fees and commissions.
What can I do to make my portfolio optimal?
The most critical advice is to make investment decisions based solely on numbers, i.e., expected return and risk relationship. The rest is likely to be a frame or noise that can obstruct good choices. Risk profiling and understanding your risk tolerance should be undertaken by genuinely independent advisors with no conflict of interest. Moreover, proper risk profiling must be done using behavioural finance techniques in addition to classic risk questionnaires focused on risk objectives and constraints.
