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How the Framing Effect Can Skew Decision-Making

The way information is presented can influence our decision-making—sometimes to our detriment—thanks to a cognitive tic psychologists call the framing effect.

“Research has repeatedly shown that whether an investment’s performance is framed as a gain or a loss can push investors to buy or sell—irrespective of its objective merits,” says Mark Riepe, head of the Schwab Center for Financial Research.

One way to counter the framing effect is to use appropriate benchmarks. “For example, investors often judge assets by comparing their performance to that of a broad market index,” Mark says. “But using a broad market index won’t tell you how an asset performs relative to its peers or within its sector—a stock that has outperformed the S&P 500® Index may still be a laggard within its industry, for instance—nor does it speak to the riskiness of the asset.”

Another strategy is to get back to basics. Say you’re interested in buying a stock that’s down 20% year to date but has recently enjoyed a strong run. Some investors might call that a loser. Others might see a winner. Both could be right depending on their time horizon.

A better approach is to ask whether the stock’s current market price accurately reflects the company’s earnings, growth potential, riskiness, and other fundamentals. Then look for counterarguments that might cause you to reconsider your conclusions, such as news that could alter the company’s growth trajectory.

Finally, it helps to judge every potential investment in the context of your other holdings. Will it add to areas of your portfolio that are already overweight? Or will it complement the finely tuned asset allocation you’ve assembled?

“Ultimately you want to focus on what really matters—and that’s whether an investment is a good fit for your long-term goals,” Mark says. “If you’re not sure, a financial advisor can help you zoom out and make clear-headed decisions.”

What You Can Do Next

Listen and subscribe to Financial Decoder, Schwab’s podcast in which host Mark Riepe explores the emotional biases that can cloud your financial judgment and cost you money.

Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone.

Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Investing involves risk, including loss of principal.

Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly. For more information on indexes please see schwab.com/indexdefinitions.

Diversification and asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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