In the world of psychology, the “framing effect” refers to a mental bias that leads us to process and react to information based on the way it is presented. For investors, this bias is particularly important because it can influence how we perceive investment performance.
To understand the framing effect, consider these two scenarios:
- One of your investments, XYZ, increases in value by $50 over the course of the year, but loses $20 of that gain due to some year-end market volatility.
- One of your investments, XYZ, increases in value by $50 over the course of the year. The markets hit a rough patch near the end of the year, but you’re able to hold on to $30 of your gain.
The outcomes are the same, yet people are more likely to prefer scenario B because it is presented as a gain instead of a loss.
The framing effect is a natural tendency of human perception and isn’t inherently bad. That said, it’s important to be aware of this bias whenever possible. When making investment decisions, try to avoid focusing on unrealized gains or losses. Instead, consider the future prospects of your investment and whether the factors that led you to acquire it have meaningfully changed. If they have, it might be time to consider selling, regardless of how much the investment has lost or gained in the short term. If not, you could stay the course and make a point to repeat this exercise at regular intervals in order to keep the framing effect at bay.