Many of the financial mistakes people make are caused by a fundamental shortcoming: They can’t see the big picture.
In behavioral economics circles, this is known as “narrow framing”—a tendency to see investments without considering the context of the overall portfolio. Many people are vulnerable to it. Are you? To find out, consider a few questions about a coin flip.
Here’s the first question, which the Nobel laureate Paul Samuelson first posed to one of his colleagues at the Massachusetts Institute of Technology: Would you accept a bet in which you win $200 if the coin lands on heads and lose $100 if lands on tails?
Prof. Samuelson’s colleague rejected this bet. Like many people, he felt that the potential pain of losing money wasn’t worth the pleasure of the bigger gain.
But here’s a follow-up question: Do you want to play this same bet twice?
When fellow behavioral economist Richard Thaler and I asked visitors to a coffee shop if they were interested in repeated plays of a similar bet, most people found the offer even less appealing. (The percentage of people accepting the wager dropped by 23 percentage points.) The logic is simple: They didn’t really like the single bet, so why would they want to play it multiple times? It’s like having an extra-large portion of a food you don’t want to eat.
Here’s the last gambling question. You have a 25% chance of winning $400, a 50% chance of winning $100 and a 25% chance of losing $200. Would you accept this bet?
If you’re like most people, you find this wager more appealing.
But here’s the catch: This last gamble is the same as playing the coin flip twice. All I’ve done is describe the overall odds. (There’s a 25% chance of getting two heads, a 50% chance of getting one heads and one tails, and a 25% chance of getting two tails.) However, this new description more than doubles the number of coffee-shop visitors who wanted to take a similar gamble.
What explains this preference reversal? Why does a new description make the same bet so much more appealing?
This gets us back to the issue of narrow framing. If you initially rejected the bets, it’s probably because you are still thinking about each coin flip independently, fixated on the 50% chance of losing money. However, when the overall odds are aggregated for you, it’s much easier to see that the gamble is quite attractive.
For investors, such narrow framing can lead to some serious mistakes and missed opportunities.
Getting risk wrong
The first mistake involves people taking too little risk, which often leads to lower investment returns. When we engage in narrow framing, we tend to focus on short-term losses, much like those people asked about coin flips. Instead of considering how the investment fits with our long-term goals—for example, comfortable retirement—we get scared by the daily swings of the market. As a result, we keep our money in a bank account earning just 0.15% or so a year. (If your money earns 0.15% a year, it will take almost 500 years to double.)
The second mistake involves people taking ontoo muchrisk without realizing it. When we don’t think about our entire portfolio, it’s easy to overlook the fact that many of our different investments might fall or fail for similar reasons. It can be smart to have some risky investments in a portfolio, but you want to make sure that all of the risks are considered together. If a lot of your wealth is tied up in your house, then you probably want to think twice about investing your IRA in a local apartment building.
The good news is that there are some simple steps you can take to minimize the potential problems caused by narrow framing.
Getting risk right
The easiest way to achieve your long-term goals, and avoid focusing on short-term losses, is to check your portfolio less often. While it’s now possible to get instant updates on the latest swings of the market, this additional information can lead to narrow framing. For instance, if those subjects offered multiple coin flips were simply told about the outcome after all rounds, and not after every flip, they would find the wager more appealing. The same goes for the stock market: Less-frequent updates can lead to smarter choices.
In the near future, I hope that our gadgets get smarter about how they deliver our financial information as a way to overcome narrow framing. For instance, if your wearable notices a correlation between market swings and reduced sleep, then perhaps it should adjust the frequency of feedback. Maybe the default setting on the stocks app should switch to monthly rather than real-time.
Another important way to reduce narrow framing is to aggregate our financial accounts. Many American workers have multiple investment and retirement accounts, spread across different firms. (This is often a consequence of people changing jobs.) The problem with having so many different accounts is that it can make it harder for us to think holistically about our finances and properly assess our overall risk exposure.
In the past, fixing this issue was extremely time consuming, and required people to manually merge all of their accounts. However, aggregation software can now make it easy to display the information from these different accounts in one place. The accounts themselves might still be held at different financial institutions, but the software encourages us to think more broadly about our investment decisions.
The larger lesson is that aggregation can help us avoid the trap of narrow framing. Like those subjects given aggregated odds about the coin flips, one of the keys to making better financial decisions is to rely on information that reflects the biggest possible picture.
This is what the best investors do: They seek out the big picture. And then, once they’ve found it, they remember not to look at it too often.
