commercial for running shoes shows two barefoot men bantering as they walk in an African savanna. Suddenly, they spot a growling lion. “Do you think you’re faster than a lion,” asks one as he watches the other put on his running shoes. “No,” says the man, “but I’m faster than you.” And with that he runs away. Next we see the lion closing in on the barefoot man who lags behind.
The man in running shoes frames the race correctly as between him and the barefoot man, whereas the barefoot-man frames the race in error as between each of them and the lion.
Traders face the same reality with stocks, bonds, and other investments. Traders who commit framing errors fail to understand that trading is a race not against the market, but other traders. It is no wonder that such traders predominate among losers.
Framing shortcuts and errors are just one of many potholes that investors encounter. Other cognitive shortcuts and errors center on hindsight, confirmation, anchoring and adjustment, representativeness, availability, and confidence.
Framing errors underlie the “winner’s curse,” where winners of auctions pay too much for what they buy. Bidders who frame auctions correctly are aware of the winners’ curse. They know that their estimate of the value of an object is likely to include both its true value and an error that might inflate its estimated value beyond its true worth. Therefore, they scale back their bids below their estimates. Bidders who fail to scale back their bids are likely cursed with overpayment when their bids turn out to be the winning ones.
“Money illusion” is yet another framing error, where we use nominal units of money in place of “real,” or inflation-adjusted, units of money. For instance, a 2% nominal pay raise when inflation is at 3% is a 1% real pay cut, whereas a 1% nominal pay raise when inflation is at zero is a 1% real pay raise. Yet we often perceive the first as better than the second; we frame pay cuts and raises in nominal money units where a 2% raise is better than a 1% raise, rather than in real money units where a 1% cut is worse than a 1% raise.
Read more: Even ‘normal people’ can be amazing with money. Here’s how.
And: Don’t make this mistake with retirement spending.
Consider this interaction in an episode of “All in the Family,” a classic 1970s television show. Archie Bunker gleefully tells Edith, his wife, Gloria, his daughter, and Michael, his son-in-law, of a labor settlement in a time of high inflation.
Edith: Archie, did you get a good raise?
Archie: Edith, a three-year contract with 15%.
Michael: Arch, what about the cost of living escalator clause?
Archie: The hell with the escalator, we’re on firm ground with 15%. Now don’t make me mad!
When Archie and Edith leave Michael speaks to Gloria:
Michael: I did not want to spoil his happy moment but he is not any better now than before…Remember reading in the paper the cost of living went up 12% last year? Next year it is going up another 8%. That’s 20%. Archie thinks that he’s 15% ahead, but he’s already 5% behind.
The first step in correcting cognitive errors is identifying them and our natural susceptibility to them. The second step is developing mental tools and using scientific tools to correct them. You might think that you can forecast stock market movements. But are you possibly committing hindsight errors? Keep a journal of