By LARRY SWEDROE
You are the commanding officer of 600 troops surrounded by the enemy. After careful analysis, you determine you have two alternatives. Alternative A is to fight it out until reinforcements arrive. If you adopt that strategy, you estimate 200 of your troops will survive. Alternative B is to attempt to surprise the enemy by sneaking out under cover of darkness. You estimate there is a one-third chance that everyone will be saved and a two-thirds chance that everyone will die. Which do you choose?
Now consider the same exact scenario, though the wording is different. In this case, your estimate for alternative A is that 400 of your troops will die. The estimate for alternative B is that there is a one-third chance that everyone will be saved and a two-thirds chance that everyone will die. Which do you choose?
While the two situations are identical, in the first case, the majority of people will choose alternative A. In the second case, the majority will choose alternative B. Psychologists explain this result by the way the alternative was posed: In the first case, the focus was on how many lives would be saved (200), while in the second case, the focus was on how many would die (400).
Each of us likes to believe we are rational when we make decisions. As rational people, when faced with equivalent situations, we should come to equivalent decisions. However, psychologists have found that is not the case for most people. Depending on how a problem is framed, we often come to very different conclusions, and mistakes are often made. That includes investment mistakes.
Consider the following examples from Jason Zweig’s excellent book Your Money & Your Brain.
The evidence from the three examples shows that if a situation is framed from a negative viewpoint, people focus on that. On the other hand, if a situation is framed in a positive way, the results are quite different. Let’s now look at two investment-related situations that illustrate how our decisions can be influenced by the way they are presented.
Indexed annuities
Indexed annuities (IAs) are products described by those selling them as providing “the best of both worlds” — the potential rewards of equity investing without the downside risks. The typical IA offering has the following characteristics:
A link to a of the positive changes in an index (typically the S&P 500).
Principal protection.
A minimum guaranteed return, regardless of the performance of the index.
Tax-deferred growth potential.
Income options to meet your specific needs.
A death benefit guaranteeing beneficiaries 100 percent of the annuity’s indexed value.
Investors may seem to find these characteristics irresistible. In 2019, Limra, an insurance industry group, projected that sales of indexed annuities would rise to $96 billion by the end of 2023, $26 billion more than in 2018. Unfortunately for investors, IAs may contain many negative features, any one of which could lead investors to conclude they should not buy an IA. The negatives can include:
Large commissions reduce the returns that can be earned.
The return is limited by either capping it or providing as little as 50 percent of the return of the benchmark index (though 70 to 90 percent is more typical). Thus, investors can miss out on much of the potential rewards of equity investing.
The return is based on the price-only return of the index and does not include dividends. (Historically, dividends have provided a significant portion of the total return of stocks.)
The return is reduced by some margin that is subtracted from the return of the index.
The return is based on simple interest instead of compound interest.
Most IAs have significant early-surrender charges that can exceed 20 percent.
The issuer can change some of the terms, such as the rate cap.
The typical IA is so complex, and filled with negative features that are difficult for most investors to fully understand, that in July 2020 the SEC issued a bulletin warning investors about them. The following warnings are contained in that bulletin:
With all the negatives, why do investors seem to love this product, buying tens of billions year after year? The reason is simple. The insurance industry frames the investment decision in a manner that gets investors to focus on the potential for large gains, the principal protection, and the guaranteed minimum return provided by annuities. Investors lose sight of the costs and the lost upside potential. In other words, “you’ve been framed”. Consider the following regarding the guaranteed minimum return and the protection of principal.
Most IAs do come with a guaranteed minimum return, historically between one and three percent. However, that guarantee is not always on the entire investment. Frequently, the company guarantees investors will receive at least x percent of just 90 percent of their investment. Why 90 percent? The reason is the insurer has paid 10 percent in commissions. The result is investors can still lose principal investing in an IA, especially if they need to cancel their annuity early—the guarantee only applies if held to maturity. And then there are those nasty early withdrawal penalties.
There is another important point to consider regarding the benefit of the guaranteed minimum return. Because the guarantee is based on nominal (not real, or inflation-adjusted) returns, the insurance has historically had almost no value. From 1931 through 2007, there was not any 10-year period when the S&P 500 Index did not produce positive nominal returns—no principal protection was needed. And from 1932 through 2007, there was only one single 10-year period when the S&P 500 Index did not produce a return in excess of 3 percent. The single exception was 1965–74, when the S&P 500 Index returned 1.2 percent per year. The bear market of 2008 added to that list—and that is how investors get framed by recent events.
One can only wonder how many investors would have actually bought these IAs if they were presented with the focus on the upside potential they had given up instead of being pitched on the downside protection (historically of little value). How the problem was framed (and lack of investor knowledge) led to costly investment mistakes.
Let’s now look at another situation where framing can lead to mistakes.
Monte Carlo simulations
Since we live in a world with cloudy crystal balls and all we can do is estimate returns, it is best not to treat a portfolio’s estimated return as a certain return. It is better to consider the possible dispersion of likely returns, and then estimate the odds of successfully achieving the financial goal. The task is best accomplished through the use of a Monte Carlo (MC) simulator.
The output of an MC simulation is summarised by assigning probabilities to the various investment outcomes. How the output is framed can make all the difference in how people look at risk. For example, the output might be presented as the individual having a 90 percent chance of never running out of money (his financial goal). Given what we have learned, it is highly likely that far more people will find that an acceptable risk than if the situation were framed from the negative perspective — a 10 percent chance of running out of assets.
Since MC output is almost always shown from the positive perspective (the odds of success are shown), it is likely people are taking more risks than appropriate. The research, and my own anecdotal experience, demonstrates that people who say that 90 percent odds of success are acceptable will answer differently if they’re told one out of 10 of them will run out of assets. Are you willing to accept that risk? That’s why I have learned that when dealing with issues related to risks, I always pose the questions from the negative perspective.
The moral of the tale
Individuals and financial advisers alike must be careful to frame problems in a way that allows analysing them from various perspectives. That is the best way to ensure that all the pros and cons have been thought through. Understanding the ways in which human beings can make mistakes, and helping them avoid such mistakes, is also a way a financial adviser can add value.