Framing – Half Full or Half Empty?Alan Fustey
Imagine that I am holding a glass that is partially filled with water. Is it half full or half empty? Either answer is acceptable because they can both be perceived as being correct.
I am still holding the same half-filled glass, but I now tell you I just drank some of it. Is it half full or half empty? Most individuals will now answer the question with half empty because they have a mind’s eye picture of me drinking some of the water.
I am still holding the same glass, but I now tell you I just filled it from the faucet. Is it half full or half empty? The answer to the question now becomes half full because you have a mind’s eye picture of me adding some of the water.
Framing refers to how the method in which information is presented can influence your decisions. As a result, the choices that you make are influenced significantly by the way problems are framed. Framing decision problems in a positive way generally results in less risky choices. While negative framing of problems tends to result in riskier choices.
The most widely cited study of decision framing was called the Asian Disease and was completed by Tversky and Kahneman (1981). It demonstrated that individuals systematically reverse their choices when the same problem was presented in different ways.
In financial markets, corporations commonly rely on a positive framing effect when they announce a stock split. A stock split is a corporate action in which a company’s existing shares are divided into multiple shares. Two-for-one is the most common form of a stock split. For example, a company with 500 shares currently trading at $10 per share will issue 500 additional shares, bringing the total to 1000 shares, which should result in the stock price trading at a revised $5 per share.
This price decline should occur because, although the number of shares outstanding has increased, the total dollar value capitalization of the shares and the underlying financial condition of the company remains the same as the pre-split value. There was no additional investment value added as a result of the split.In a study (Garcia de Andoain 2009) that evaluated the effectiveness of corporate stock split announcements, it was shown that “after an announcement of an upcoming split, share prices increased, which was caused by investors that reacted favourably to the announcement by buying more shares”.
The announcement of a stock split frames the perception that investors have about the shares in a positive way, since they will now have more of the investment. Ironically, a stock split can result in increased trading costs for individual investors when they buy and sell the corporation’s shares in the marketplace. This occurs because trading costs are frequently based solely on the number of shares traded, rather than the value.
Framing can also influence how you view data presentations. If you are told that “35 times out of 100 an investment strategy fails” this tends to have a more negative frame than being told “65% of the time this strategy is successful”. Therefore, if you are told that “35 times out of 100 an investment strategy fails” your decision choice is likely to be affected by both your more accurate understanding of the odds calculation of the data, but also by the negative frame in which it was presented.
The next time a financial advisor presents a data sequence to you as an evidence for accepting a risky decision, try reversing the format of the presentation and the frame that is being used, so that you truly have an accurate understanding of the choice.
Posted: November 30th, 2012 under Financial Planning, General, Investments, MONEY®, Personal Finance.
Tags: Alan Fustey, behavioural finance, investment decision making, personal investment strategies