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How you frame investing decisions matters

(MoneyWatch) Each of us likes to believe that we're rational when we make decisions. As rational people, we should come to equivalent decisions when faced with equivalent situations. However, psychologists have found that's not the case for many of us.

Depending on how a problem is framed, we often come to very different conclusions. Investing is no different. Consider the following example from Wall Street Journal personal finance writer Jason Zweig's excellent book "Your Money & Your Brain." A study asked more than 400 doctors whether they would prefer radiation or surgery if they became cancer patients. Among the physicians who were informed that 10 percent would die from surgery, half said they would prefer radiation. Among those who were told that 90 percent would survive surgery, only 16 percent chose radiation.

This illustrates how people tend to focus on the negative aspects of a decision if that's what's emphasized. On the other hand, if the situation is framed positively, the results are quite different. Let's now look at how an investment decision is framed can influence our decisions.

Since we live in a world with cloudy crystal balls, all we can do is estimate investment returns. Thus, it is best not to treat a portfolio's estimated return as a certain return. Instead, one should consider the range of likely returns and then estimate the odds of achieving the financial goal. One way to do that is through a so-called Monte Carlo simulation, which takes inputs about your financial situation and generates several hundred potential market scenarios. Those scenarios are aggregated to give you an estimation of how likely your investment plan will achieve its goal, such as having a certain dollar amount to leave to family or simply not running out of money in retirement.

How the Monte Carlo results are framed can make all the difference in how people perceive risk. Consider the same information framed two different ways:

  • A 90 percent chance of not outliving your assets
  • A 10 percent chance that you will outlive your assets

It's my experience that Monte Carlo results are almost always shown from the positive perspective. Thus, it's likely that there are people taking more risks than is appropriate, especially since outliving your financial assets is an unthinkable outcome.

I prefer to frame the outcome from the negative perspective. Using the above 90/10 example, I ask the investor to imagine that they're in the same situation as nine other investors. We know that one of the 10 will outlive their assets based on the chosen asset allocation and spending plan. I then ask if they're prepared to accept the risks of being that person. It often results in a very different response than if the output was only discussed from the perspective of a 90 percent success rate.

While an estimated 90 percent odds of success will be acceptable to many people, it certainly isn't appropriate for all. Whether it is depends on your ability to adapt your plan to deal with the impact that a severe bear market can have on the likelihood of outliving your assets. If you have a realistic backup plan for asset shortfalls a 90 percent odds of success is probably appropriate.

On the other hand, if you don't have any acceptable options, a 10 percent chance of failure is likely too high to accept. Examples of actions you could take to reduce the risks of failure include, remaining in or returning to the work force, reducing current spending, reducing the financial goal, selling a home and/or moving to a location with a lower cost of living.

When faced with an investment decision, be careful to frame the situation in a way that allows you to view the problem from various perspectives. That's the best way to be sure that all the pros and cons have been considered. And it is the best way to avoid making costly mistakes.

Image courtesy of Flickr user 401(K) 2013

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