Portfolio Ideas. Frame yourself to take optimal decisions

Last week, we discussed about how commitment savings moderates the battle between your present self and your future self. But your future self may not always be the problem. Sometimes, you do not take a personal finance decision because your present self is not convinced about the action. Here, we discuss how to nudge yourself to take such financial decisions by applying the framing effect. Together with commitment savings, framing effect can help you make optimal choices to achieve your life goals.

Framing effect

Framing effect occurs when you take decisions or interpret an issue differently just because the problem is presented to you in a different way. Consider this. You want to convince a 25-year-old professional to start saving from today for her retirement that will happen 35 years hence. What if you tell her that starting to save early will enable her to lead to a comfortable post-retirement lifestyle? Would that motivate her to start saving from today? Highly unlikely.

The reason is simple. She, like most of us, will suffer from present bias. That is, we value today’s happiness much more than the happiness that we can experience in the future. And money that is not saved for retirement is money available for spending today.

But what if you ‘frame’ the statement differently? What if you tell her that not saving early for retirement would mean that she will fail to have a comfortable post-retirement lifestyle?

Framing the statement as a comfortable post-retirement lifestyle is referred to as “gain frame”, whereas stating that the individual will fail to have a comfortable lifestyle is referred to as a “loss frame”. Now, negative framing is useful to motivate an individual to take an action. Why? The reason is that we are risk-seeking when we want to prevent losses and risk-averse when we want to protect gains.

Recall the last time you bought a stock and it declined in price. Did you sell the stock at a loss or hold on to your losses? If you did the latter, you were taking more risk to avoid the losses, for the stock could have declined further. But what did you do when the stock you bought climbed up sharply? You, perhaps, hastened to take profits for the fear of losing your unrealised gains!

It is the same behaviour that is at work when you pose a decision or question as a “gain frame” or a “loss frame”. Note that the “loss frame” can drive you to take action only if you are able to clearly relate the non-action to the eventual outcome.

Investment framing

So, you are disinclined to investing in equity. Of course, you could lose some capital if you invest in equity as opposed to investing in bank deposits. But the expected return on equity is higher than that on bank deposits. Therefore, change your perspective about equity investing. Do not just look at the risk of investing in equity. Consider instead the risk of not investing in equity. If you do not invest in equity, your portfolio is unlikely to meet your life goal because the actual return on investments will not meet the required return. Also, your portfolio will not be geared to catching up with inflation. This “loss frame” will lead you to realise that investing only in bank deposits is not a safe choice but a sure way to fail in achieving your life goal!

Similarly, you can “frame” your decision regarding life insurance plans. If you view insurance premium as a cost, you will be able to accept term insurance as indemnifying your family’s loss of income and protecting their standard of living. If you instead view insurance as an investment, you are likely to choose products such as unit-linked insurance plans over term insurance!

The author is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

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