Framing effect proposes that individuals make decisions based on how an issue is presented, or “framed,” rather than on the facts presented. It is a cognitive default to choose an option that is more positively presented, or framed.
Framing effect, sometimes called framing bias, is apparent across most every field of human endeavor, when people are faced with making a decision based on facts presented in a particular way. Ultimately, framing bias is a powerful component of our investing, presentations, communications, and shopping, among other activities.
Key Takeaways
- Framing effect is a powerful communication tool used to convince people to take an action based on their emotional response, rather than on the facts of the proposal.
- Framing effect is used in every form of communication, from visual to written content, and is influenced by body language to color choices.
- For investors, framing effect plays off our instinctual predispositions to avoid loss and maximize gains.
- To avoid framing effect, investors need to look beyond the surface proposition and instead focus on concrete data points to best determine if an investment is favorable.
Framing Effect Explained
Because the framing-bias theory arises from individual reactions to a two-way proposition, it is important to note two other cognitive biases that most people exhibit subconsciously with framing choices:
First among cognitive biases is that the fear of loss is greater than the prospect of winning, even though the odds may be identical. People will almost always choose an option that maximizes the prospect of a positive outcome, while avoiding responses that entail a risk of loss. For instance, your financial advisor may present two options for your investment portfolio:
- A well-diversified portfolio that has a 70% chance of producing positive results
- A well-diversified portfolio that has a 30% chance of losing money
Clearly, most people would respond more favorably to the first option because it emphasizes gains, while the second option focuses on potential losses—even though the results are actually the same.
Second, people tend to favor larger numbers over smaller ones when making decisions. This cognitive reflex stems from people’s impression that something with a larger number behind it is more persuasive. For example, let’s say you’re a car dealer looking to get the best response to an ad campaign and you come up with the following two options, both of which will result in the same price:
- Get $1,000 cash back when you buy the car
- Get 5% off the selling price of the car
Given the two options, most people would take the first because it involves a very large number plus cash being transferred to the buyer. The second choice involves the buyer calculating how much the 5% discount is relative to the $1,000 offer, which is likely to put off potential buyers.
Here’s another simple example related to investment options:
With an initial public offering (IPO) pending, your investment advisor lays out two possible outcomes for the investment:
- There is a 70% chance of success, and the shares are expected to go up by 45% on the first trading day.
- There is only a 30% chance of failure, but if the IPO succeeds, then the stock price may scale up by almost 45%.
Both propositions represent the same potential outcome, but investors are most likely to choose the first option because it is framed positively, while the second option is framed negatively.
Framing Effect and Investing Decisions
With framing effect used in every field of communication, we must be prepared for it to appear in financial and investing materials and advertisem*nts. Here, investors are frequently given two choices for how to invest their money, phrased, or framed, with two biases—both with the same ultimate outcome. When the same piece of information is presented in different ways, the response varies.
In financial decision making, framing effect can lead to serious consequences. This is apparent and should be acknowledged when an investment is pitched to investors or a product is introduced to potential clients or buyers.
For example, suppose an investor is presented with the two following investment options regarding a 10-year U.S. Treasury bond:
- The bond offers a 10% fixed return every year.
- The investor’s money will double in 10 years.
The first option is phrased positively for those who are seeking a secure, steady stream of income, while the second option may have negative connotations if the investor is reluctant to lock up their money for a full 10 years.
Other investment decisions, such as picking which mutual fund to invest in, are ripe for the framing effect. For instance, consider the following choices:
- Option A: A mutual fund that has beat the market benchmark by 5% in the last year
- Option B: A mutual fund that has beat the benchmark by 2% each year over the last three years
It might seem clear that most investors would probably choose Option A, as it shows the highest rate of return over the immediate past year, while Option B shows a lower rate of return over several years. However, this scenario represents a false dichotomy—both outcomes are unknown. For example, both funds might lose significantly compared with the benchmark in the upcoming year, so investors can’t make a definitive choice based on the data presented.
Four Types of Framing Effect
Behavioral finance studies have broken down the types of framing effect into four main categories. They all contribute to a framing effect in their respective example presentations, which most people never even notice.
Auditory Framing
Auditory framing occurs when there is a spoken proposition that can be delivered in different tones and manners. Studies have shown that how a proposition is presented is more important than what is actually communicated.
For example, when visiting a car dealership, customers are more likely to do business with a salesperson who delivers a sales pitch in a confident and compelling tone of voice, while a more timid and quiet salesperson is not likely to get customers’ attention.
Visual Framing
Visual framing involves everything that is communicated in a visual manner, such as colors, font, type size, and body language. An example of a visual framing presentation could involve font size and style. A type style that’s clear and distinct, making it a positive candidate for advertising copy, would likely be the best choice, in recognition of the framing effect.
Body Language
Studies have shown that body language accounts for 55% of the material being communicated. Again, this is an innate component of our natural means of absorbing information, of which we are all too often unaware. For example, we are more likely to be receptive to a speaker who has a commanding voice, solid body language (face forward, arms open in a welcoming gesture, etc.), and a fluid speech cadence.
On the other hand, we are unlikely to be attracted to or listen to a speaker who shows poor body posture, speaks in a weak voice, and generally comes across as nervous or unsure.
Value Propositions
Value propositions are based on the technique of making us feel like we are getting more for less. For example, say a computer shop is selling Apple Macs for $1,000 and is looking for the best way to market a special sale that it’s running. Which should it feature?
- Option 1: $200 off a new Apple Mac
- Option 2: 20% off a new Apple Mac
Because of the phrasing used, the $200-off deal appears to be the best to most consumers, even though the ultimate price is the same in this case. This illustrates two facets of the value proposition:
- The rule of relatively large numbers discussed above
- The phenomenon in which the price of a particular good is seen to be better with a dollar-based discount—in this case, $200 vs. 20%
Positive and Negative Themes
As shown, the phrasing we encounter can have a significant psychological impact on our decision making.
In general, we seek the lowest risk available and are prone to favor large numbers vs. small numbers, even if the result is the same.
A negative ploy frequently used by retailers is language along the lines of “don’t miss out on our great sale” or “last chance to get this deal.” Both frame the proposition in negative terms, meaning we are being told to take action to avoid a loss. By virtue of its prevalence, the negative framing effect must be successful, perhaps because it matches with our instinct to avoid a loss or find a better deal.
How to Avoid the Financial Pitfalls of Framing Effect
Most importantly, investors need to be aware that framing effect exists in the financial sphere, as with many other kinds of decision making, and so is likely to appear prominently in financial companies’ advertising and promotional materials. Simply embracing that truism can help investors be more conscious of framed choices when they are presented. Remember, if it sounds too good to be true, it probably is.
Other steps to take to avoid the negative consequences of framing effect are:
- Act rationally in your investment decisions. Do the homework that goes beyond the framing effect’s lure. Analyze your investment options with an open mind, and have a solid foundation (such as earnings per share [EPS], internal rate of return [IRR], or price/earnings to growth [PEG]) on which to base your investing decisions.
- Do a gut-check analysis of any investment. Don’t fall for results based on past performance, as they have no impact on future performance. If it feels right, maybe you have something good on hand; if it doesn’t feel right (or your research finds holes in the investment), let it pass. The next solid investment opportunity will be right around the corner.
- Keep a long-term perspective in your investing, and avoid promises of get-rich-quick schemes. Stay focused on the long-term horizon and the accumulation of wealth over time (also referred to as compounding).
What is an example of framing effect being used to influence behavior?
Framing effect is frequently used in sales rhetoric, including for investment products, to play on our innate instincts to seek the best deal possible or to spend as little as possible. Advertisers are expert in using framing effect to boost sales and establish customer loyalty. In that sense, sell-side companies or organizations have a high degree of interest in maximizing the effect of their advertisem*nts or brand promotion, by framing their products or services in ways that can steer us toward making the desired choice.
Is everything I read or see ‘framed’ for me?
Most likely, yes. If the message giver is adept at all at delivering a compelling message to its audience, it will review its communications to find better, more compelling ways to address the subject at hand, whether it’s a sales campaign or a mutual fund launch.
How can I avoid being misled by framing effect?
Focus on the facts presented in the “framed” argument to see what the message is really saying. Sometimes it will be easy to spot a framed message, and other times it will be more complicated, depending on the nature of the issue. But by being aware of the various instinctual responses and biases we exhibit in our decision making, we can get closer to the truth of the messaging and be less subject to manipulation by the way the message is framed.
The Bottom Line
Investors need to be aware of framing effect to avoid being taken in by a get-rich-quick scheme or any other dubious investments. The first step to combat framing effect is to recognize it exists and may influence our decisions. This makes it incumbent on individual investors to do their own investment research, seeking out key metrics such as EPS, PEG, or IRR, before committing capital.
While framing effect can be useful in giving investors a starting point from which to compare alternative investments, it’s still up to the investor to make the call. Always remember that past performance isn’t indicative of future performance, and that if an investment sounds too good to be true, it probably is. Finally, rely on your gut instinct to see through the framing effect and conduct your own independent investment analysis before making decisions.
