The Framing Effect

Framing Bias is a congnitive bias. From Wikipedia;

“The framing effect is an example of cognitive bias, in which people react to a particular choice in different ways depending on how it is presented; e.g. as a loss or as a gain. People tend to avoid risk when a positive frame is presented but seek risks when a negative frame is presented.”

Consider this example, posed by Dr. Daniel Kahneman, Nobel Prize-winning author of Thinking Fast and Slow:

1. Would you accept a gamble that offers a 10-percent chance to win $95 and a 90-percent chance to lose $5?

2. Or, would you rather pay $5 for a lottery ticket with a 10-percent chance to win $100 and a 90-percent chance of winning nothing?

Think before you choose either. Have you decided? No Peeking. So, comfortable with and believe you have made the made the right choice?

The answer is both are the same, but research says most people when presented with the above options and who think themselves as rational decision makers would opt for Choice 2. Why?

Because of the way the question has been framed you feel that buying a lottery ticket for just $5 is way better than a 90% chance to lose the $5.

The other day I wrote on why I believe that Individual Traders / Investors are better off not trading in Individual Stock Futures and in a way (which I really didn’t intend to) was framing it in a way that people felt that there was a way higher risk than what they perceived.

Before we get further, let first understand what stock futures are and why more people end up loosing than what a simple coin toss odds will foretell.

From time immemorial, people have taken on debt to try and achieve their goals earlier than what it would if one needed to save the whole amount. Think of a housing loan for instance. How many home buyers can afford to buy a home if they were required to put up 100% of the amount vs the current concept of putting up a small initial deposit and pay the rest with interest as time passes by.

If no one is allowed to take debt for buying their own house, the housing market will crash for the simple reason that disciplined saving is way tougher compared to the discipline of paying off the EMI since otherwise you may tend to loser ownership of that house and its not just the financial loss that will pain you but the ignominy of being seen as a failure by those who know you.

Now, lets come back to Stock Futures and how similar it is to the Housing Loan.

Lets assume that you believe that government will focus on Infrastructure and hence Infra companies that have been bogged down could see better days. Lets assume based on the above rationale, you choose J P Associates as the company you want to invest into.

Lets assume you currently have around 2.5 Lakhs that you want to risk in the market. The rational thing to do would be to spit that into 10 or 20 equal measures and invest each such measure into a individual stock. That would mean that you could buy 2170 shares of JP Associates if you invest 10% of your capital into that company (25,000) or 1085 shares if you were to allocate 5% of your money into the said company.

Lets for sake of understanding assume that you have done a lot of research and that research tells you that JP Associates will bloom in the future and given that its all time high is 339, if you are right, this stock could go way way higher.

Given this scenario, would you opt for buying 2170 shares or 1085 shares or would you think on lines of, given how much I know why not take a loan and pump in more money since the rewards will then multiply by the leverage factor.

Lets for a moment get back to the housing example. Two friends analyze the housing market and feel that its ripe for a big up move and they should take advantage of the coming boom. Person A saves a lot of money and finally buys a house without taking a loan for 50 Lakhs. Person B saves a small amount (10% of the value of the house) and takes a loan for the rest 90% and buys a house for 1 Crore.

With housing prices booming, lets assume that property prices acquired by both Person A and Person B have appreciated by 100%.

For Person A, its a pure doubling money. He had invested 50 Lakhs and sees a profit of 50 Lakhs. He is happy until he turns around and sees that Person B who put in 10 Lakhs is now seeing a profit of 1 Crore, 10x the investment. Given that both had done the same analysis, do you think that person A will really be happy with the outcome he is seeing now?

Lets get back to our JP Associates case. You feel that this being one sure bet, maybe you should bet it all – 2.5 Lakhs and wait for it to move up as your Analysis tells you it will. 2.5 Lakhs will get you 21,000 Shares. At this time comes in the Spider who tells you that why stop at 21K, when the same 2.5 Lakhs can get you exposure to 68,000 shares.

In earlier days (and even these days) brokers offer what is called margin finance where you buy stocks while putting up only a part of the investment. If you are right, your returns explode and who thinks that things can go wrong – always be Optimistic is what he have learnt in Life.

But for JP Associates, you don’t need a kind broker to help you. The exchange itself will provide a medium where you can borrow. All it asks you is that you fulfill the margin requirement as well as the day to day, Marked to Market difference.

If you are not exposed to Futures and Options, you may think which irrational fool will take that path, but then again all you need to do is visit a broker’s place and see for yourself how the herd behavior will influence one to take more risks that he should if had analyzed the whole scenario much more carefully.

So, now that we are convinced that JP Associates will move higher, way way higher and we aren’t satisfied with just a small token quantity, we convince ourselves that nothing will go wrong and jump into buying a single contract of JP Associates.

We are now proud owners (not in real sense) of 68,000 shares of JP Associates which means that every time it goes up by One Rupee, we are seeing a profit of 68,000 and since our capital is 2.5 Lakhs, we are up by a awesome 27% of our capital (remember, a Fixed Deposit gives you 7.5% for giving it money for a year). Man, we can start dreaming.

A couple of days later, comes a news item that a certain bank is proceeding with confiscating certain assets of JP Associates and the stock promptly goes down like a brick. Theoretically that shouldn’t cause a problem, after all we have put in 2.5 Lakhs right and even though the stock is down 10% from our entry, its just a loss of 68,000 and big as it may sound, we still have 1.80 Lakhs available.

In 2007 when housing prices started to fall in the United States, those who have taken loans to buy their houses found that many banks had started to ask for them to make up the difference (since most housing loans were to the extent of 100% of the property value). But having invested everything they had, how the hell were they to come up with more money. By 2008, prices had fallen so much that even those who had paid back a lot found that their house value was lower than they still owed to the Bank. With job losses, many were forced to relinquish their homes, something they had paid a lot for (in monthly installments) while getting back nothing.

Back to our JP Associates trade. While we think we still have money, we are actually in negative equity since NSE demands that you plonk up 2 Lakhs as Margin for every contract you wish to hold. Given that we had 2.5 Lakhs to start with, with the loss of 68,000, you are now having a debit balance of 18,000.

Depending upon your broker, you will either see him closing out your position without even giving a chance for you to replenish the amount or shall call you up and ask you to immediately replenish or else position will be cut. Either way, you will need to put in more money to hold that position.

But if we had invested the whole capital we had, where else can we bring fresh capital from? I have seen clients Beg or Borrow from others in the hope of maintaining the said position. In fact, years earlier, I myself had come to face a very similar situation and its in those situation you not only realize who your real friends are but realize how stupid you have been with your money.

But that is for later, what comes first is the requirement of more capital. If you can bring it in the time they provide, your position will be saved, else, its closed and regardless of how JP Associates moves from here, you will have nothing to lose or gain.

So, when I said 95% of clients on the longer term end up loosing, its not because they were stupid but because most of them were financially unprepared. When you use Leverage, its a double edged sword and yet people believe that only one edge is what matters to them without focusing on the dangers brought by the other edge that could cut your neck in no time.

Stock futures are a good product if you can use them wisely (more on that in another post) but if you are using it as a quick way to becoming rich, Good Luck. The 5% who are out there eating up the losses of the rest 95% losses (remember, futures is a Zero sum game) know for sure that Luck can only last so long. Some point or the other, you will throw in the towel after having seen your capital being decapitated several times.

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so. – Mark Twain