An economist explains how giving investors more information can be detrimental for them
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The idea of weighing risks against rewards is one of the most basic concepts in investing. However, most investors might not actually be as good at it as they think.
The problem comes from not seeing the big picture, known in behavioural economics circles as “narrow framing,” according to Dr. Shlomo Benartzi, a professor and co-head of the behavioural decision-making group at the UCLA Anderson School of Management.
In a contributed piece to the Wall Street Journal, he described how people generally refused a bet where they would win US$200 on heads and lose US$100 on tails. When he and fellow behavioural economist Richard Thaler asked a group of coffee-shop visitors if they would play the same bet twice, “most people found the offer even less appealing”: 23% fewer people accepted the wager.
“The logic is simple: They didn’t really like the single bet, so why would they want to play it multiple times?” Benartzi said.
He then detailed another gambling scenario wherein people have a 25% chance of winning US$400, a 50% chance of winning US$100, and a 25% chance of losing US$200. “This last gamble is the same as playing the coin flip twice. All I’ve done is describe the overall odds,” he said. “However, this new description more than doubles the number of coffee-shop visitors who wanted to take a similar gamble.”
The problem, Benartzi explained, is that people tend to consider individual bets independently, fixating on the risks for each, when they should actually consider the aggregate risks.
This narrow framing could lead people to take on too little risk: they may avoid the daily swings of the market and put their money in a bank account that earns just 0.15% a year. On the flip side, people could take on too much risk, building their portfolio with various adventurous investments that are even riskier when taken as a whole.
For investors to get risk estimates right, Benartzi suggested a few strategies. For example, getting instant updates on one’s portfolio could lead to narrow framing, so from a psychological perspective, it could be better to check on one’s portfolio less often.
“In the near future, I hope that our gadgets get smarter about how they deliver our financial information as a way to overcome narrow framing,” Bernartzi said. “For instance, if your wearable notices a correlation between market swings and reduced sleep, then perhaps it should adjust the frequency of feedback.”
He also suggested that investors try to aggregate their financial accounts, noting that many workers in the US maintain multiple investment and retirement accounts. “The problem with having so many different accounts is that it can make it harder for us to think holistically about our finances and properly assess our overall risk exposure,” he said.
According to Benartzi, aggregation software can show people the information from their different accounts in one place, even if they’re held at different financial firms.
“This is what the best investors do: They seek out the big picture,” he said. “And then, once they’ve found it, they remember not to look at it too often.”
For more of Wealth Professional's latest industry news, click here.
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Why mutual fund investors earn less than their funds
What protections are in place for at-risk senior investors?
The problem comes from not seeing the big picture, known in behavioural economics circles as “narrow framing,” according to Dr. Shlomo Benartzi, a professor and co-head of the behavioural decision-making group at the UCLA Anderson School of Management.
In a contributed piece to the Wall Street Journal, he described how people generally refused a bet where they would win US$200 on heads and lose US$100 on tails. When he and fellow behavioural economist Richard Thaler asked a group of coffee-shop visitors if they would play the same bet twice, “most people found the offer even less appealing”: 23% fewer people accepted the wager.
“The logic is simple: They didn’t really like the single bet, so why would they want to play it multiple times?” Benartzi said.
He then detailed another gambling scenario wherein people have a 25% chance of winning US$400, a 50% chance of winning US$100, and a 25% chance of losing US$200. “This last gamble is the same as playing the coin flip twice. All I’ve done is describe the overall odds,” he said. “However, this new description more than doubles the number of coffee-shop visitors who wanted to take a similar gamble.”
The problem, Benartzi explained, is that people tend to consider individual bets independently, fixating on the risks for each, when they should actually consider the aggregate risks.
This narrow framing could lead people to take on too little risk: they may avoid the daily swings of the market and put their money in a bank account that earns just 0.15% a year. On the flip side, people could take on too much risk, building their portfolio with various adventurous investments that are even riskier when taken as a whole.
For investors to get risk estimates right, Benartzi suggested a few strategies. For example, getting instant updates on one’s portfolio could lead to narrow framing, so from a psychological perspective, it could be better to check on one’s portfolio less often.
“In the near future, I hope that our gadgets get smarter about how they deliver our financial information as a way to overcome narrow framing,” Bernartzi said. “For instance, if your wearable notices a correlation between market swings and reduced sleep, then perhaps it should adjust the frequency of feedback.”
He also suggested that investors try to aggregate their financial accounts, noting that many workers in the US maintain multiple investment and retirement accounts. “The problem with having so many different accounts is that it can make it harder for us to think holistically about our finances and properly assess our overall risk exposure,” he said.
According to Benartzi, aggregation software can show people the information from their different accounts in one place, even if they’re held at different financial firms.
“This is what the best investors do: They seek out the big picture,” he said. “And then, once they’ve found it, they remember not to look at it too often.”
For more of Wealth Professional's latest industry news, click here.
Related stories:
Why mutual fund investors earn less than their funds
What protections are in place for at-risk senior investors?
