Framing bias

[KDL23]

Hello,
I do not understand the example in the blue box on Pg 191 in Schweser. It relates to framing bias:
First, expected returns are shown in 95% confidence interval
Then, the expected returns and their std deviations are shown
If investors show loss aversion and framing bias, under which conditions would the inestors be likey to pick the lowest return portfolio?
I really don’t understand the answer given in the book. Couls anybody please clarify!!!!

 

[cpk123]

If you had a loss aversion bias - you would look at the set of portfolios in terms of “returns” possible (along with the ranges established due to the Std deviation. So the lowest possible loss portfolio - which would be the one with the lowest mean would be selected.
however with a framing bias - the highest possible return portfolio (without considering the std deviation) would be taken. You are framed by the returns.

 

[VR]

Scenario 1 - 3 Portfolios with range of return at 95% confidence as below:
A: 0.1% to 6.7%
B: - 1% to 10%
C: - 2% to 20%
Investor is asked to choose.
Scenario 2 - Same 3 portfolios - now instead of range of return, mean and std dev are provided at 95% confidence interval.
A: avg ret = 3.4%, std dev = 1.68
B: avg ret = 4.5% std dev = 2.81
C: avg ret = 9% std dev = 5.61
Investor is asked to choose.
Now the question was in which Scenario will the investor pick the lowest return portfolio? In Scenario 1.
In scenario 1, due to loss aversion & framing bias, investor picks A (A is framed only with positive returns; investor does not like the negative returns of B & C)
in scenario 2, due to loss aversion & framing bias, investor picks C (likes the higher return of C; though std dev is provided it is not directly shown how it could translate into a negative return - typical framing)
Incidentally, in my opinion, the investor needs to exhibit both loss aversion and framing bias to pick A in scenario 1 and C in scenario 2. In Sc 1, the framing emphasizes the negatives and the loss aversion makes him avoid the negatives. In Sc 2, the framing emphasizes the positives and the loss aversion makes him go for the highest positive return. Without the loss aversion the framing might not have mattered or mattered less. For example, an investor who’s not loss averse, may have still opted for portfolio C by simply looking at the 20% outlier return.
Also note that the portfolios I’ve used in scenario 1 & 2 are identical.
Here’s how I calculated the avg return and std dev if you are interested:
avg return = (0.1 + 6.7)/2 = 3.4%
std dev = (6.7 - 3.4)/1.96 = 1.68 where 1.96 is the two-tailed z-score of the 95% confidence interval. Alternatively you could use (0.1 - 3.4)/1.96 = - 1.68. You can calculate the other numbers similarly.

 

[Belief]

Thanks VR, your detailed explanation is really helpful!

 

[zulu007]

Very helpful.