Portfolio Management | June 11, 2021

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.