fat-free-2|investment facts|frarme dependence in investing|Frame Dependence

Investor Biases: Frame Dependence

December 14, 2016

There’s a famous story about rabbinic student that approaches his Rabbi and asks, “Rabbi, am I allowed to smoke when I’m praying?” to which the Rabbi affirmatively responds “Absolutely not. It’s a disgrace to God and a disgrace to prayer." Bothered by the response, a couple days later the same student returns to the Rabbi, and says “Rabbi, am I allowed pray while I’m smoking?” To which the Rabbi responds “It’s not just allowed, you’ll set a beautiful example for all the other smokers.” This is a perfect example of frame dependence.

The term framing (or frame dependence) means that the way people respond to situations depends on how the situation is framed or presented, rather than on the actual facts of the situation. In other words, in making investment decisions, investors are usually more influenced by how the information is presented than what information is presented.

Investment companies know how to market their products by appealing to these biases, being acutely aware that via the presentation you can get the truth to tell any lie you want.

A classic example of this is the narrative behind many principal protected notes (PPNs). PPNs attract investors by guaranteeing their principal with some exposure to the equity markets, thus providing all the upside of the market with limited downside. Investors pay exceptionally rich fees to invest in these vehicles, thinking they have just discovered nirvana. However, with further analysis, investors would realise that PPNs have considerably more moving parts than they think and will unlikely return the result they were anticipating. Proof of this lies in the fact that a large majority of the people who produce these PPNs don't even buy them for themselves.

To prevent being the vulnerable one in these scenarios and letting frame dependence get the best of you, it helps to remember that every transaction has two parties - buyer and seller. And if something is so good, why would someone else – particularly the institution selling you the product – take the other side of the trade? So, in approaching opportunities, always ask about the rationale and motivation of the organisation or individual presenting the information.