Gains and Losses – remember the frame
As the revered Chinese general Sun Tzu stated, a key element of winning a battle is knowing ourselves. That can be hard. Most of us like to think of ourselves as largely rational, with a good understanding of what drives our choices. If we’re honest, however, that isn’t always the case. This is particularly true when the stakes are high and the pressure is on. Here, rationality and good judgement can go out of the window.
Investors are currently facing exactly that kind of scenario. Fortunately, since the time of Sun Tzu, researchers across the broad field of decision science have clearly documented where we predictably go wrong and what we can do about it. So, over the coming months, we’ll be sharing a short weekly insight that will help you know yourself, make better choices and hopefully fight a hundred battles without disaster.
We’re going to start with something that is incredibly timely – what disease management protocols can teach us about how we take risk.
Risky Choices
Investing requires that we make choices and trade-offs with numbers. Some are easy:
Anyone with the most basic grasp of numbers will see that the choices are identical. When investing, however, the decisions that we face are rarely as clear.
This is nicely highlighted by Amos Tversky and Daniel Kahneman’s famous experiment, known as ‘The Asian disease problem’. Although created nearly forty years ago, it’s incredibly relevant to the challenges the world is facing today.
The experiment asked participants to consider the following scenario:
The US is facing an outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternate programmes to combat the disease have been proposed. Participants were given the scientific estimates for the programmes’ effectiveness and asked to select one. The options are set out below. Do the experiment – which do you prefer?
There is no right or wrong answer here – it’s about how people interpret information and their preferences. The results were as follows:
Tversky and Kahneman were interested in understanding how information presentation influenced people’s preferences. So they took the same outcome, framed it in a different way and tested it on a different group of subjects. Again, do the experiment, which do you prefer?
Feel different to you? It certainly created a very different result. Despite the scenarios being mathematically equivalent, the reframing led to participants’ preferences being almost exactly reversed.
What does the experiment tell us?
This research and the wider body of work it sits within tell us two important things. First, we can be very sensitive to the way that information is presented to us. Second and perhaps more importantly, our preferences for risk change according to the perception of the certainty of an outcome and whether we perceive we are in a loss or gain situation.
Thus in option A when our attention is drawn towards saving lives, many prefer the sure thing. When outcomes are perceived to be bad, e.g. option C, most prefer to gamble.
Why is this important for investors now?
For a range of investors, particularly pension funds, current market activity is leading to discussions about de-risking, or re-risking investment portfolios to meet objectives. This may lead to analogous ‘gamble’ or ‘sure thing’ discussions.
So what should both advisers and clients be thinking about in this context?
- Every choice comes with a frame. Sometimes these will be deliberate, sometimes unintentional, but the frame will be there. Ask yourself, would I feel differently about something if it was presented in a different way, e.g. my portfolio has lost 5%, versus it has retained 95% of its value? There is no ‘right’ approach, we just need to remember that different frames are likely to create different perceptions.
- Our propensity to take risk can be malleable. Choices between ‘gambles’ and ‘sure things’ may be different depending on whether we perceive we are in a ‘loss’ or ‘gain’ scenario. We need to be very careful about how the context for a choice is set.
- Complex decisions with numbers can be hard for many people. Most of us who work in the field of finance are highly numerate. Situations that may seem obvious to us won’t be to everyone. To help people make good choices, we need to be constantly checking whether there is clear understanding of the factors influencing a decision. If you’re a client and your adviser isn’t explaining choices in a way that helps you clearly understand the options, then ensure that they do.
As always, both the science and practice of real-life decision-making is more complex than a blog post allows. If you’re a pension fund trustee or other institutional investor and would like more information, please contact paul.richards@redington.co.uk.
