Get to know the psychology behind the way you manage your finances; it could add up to better investment decisions and greater rewards.

Framing and Your Behavior
The way information is presented to us is called framing, and it's a major factor in determining how people invest. Consider this proposition. Suppose your financial advisor frames a choice centered on a potential $600 loss in this way: ·

• Option A: You'll pay $400. · .
• Option B: You'll have a one-third probability that you'll pay nothing and a two-thirds probability that you'll pay $600.

It probably comes as no surprise that most people would opt for the second option. "Give me the one-third chance option," says Stephanie Andelman, a client services manager for Post Communications, an email marketing firm. "The slim possibility of coming out even far outweighs the absolute determination of money lost." The reason that a certain loss of $400 is worse than a two-thirds probability of losing $600 for most people has to do with the concept of gains and losses. The first choice implies that you'll hold onto $200 (a gain). The second choice implies you can avoid certain loss by taking a risk. Studies show that people are afraid to take risks when trying to obtain gains, but are more apt to take them when trying to avoid loss. This is why a gambler on a long losing streak will keep playing to attempt to obliterate his prior losses and why a winner will often hold on tighter to the winnings and walk away from the poker game.

So trying to obtain gains, whether in the stock market or everyday purchasing, is linked to different risk-taking behavior than trying to avoid losses. Think of the financial advisor who tells you "This stock has shown a gain of 15 percent year-to-date earnings; this other one dropped 14 points yesterday." The first one sounds better, right? But hold on. What's the reference point? A gain of 15 percent on a stock that was worth $.05/share doesn't mean that much, particularly if it drops back down the following day. And the share that dropped 14 points yesterday could have dropped for the first time in 8 months and today is right back up there again!

The Availability Heuristic
Heuristics are tricks or rules of thumb for figuring something out that have often worked in the past and may do so again. The availability heuristic is a cognitive shortcut for estimating the frequency of certain events by considering how many such events come to mind. But this shortcut isn't always a good gauge when it comes to investment decisions.

Consider the experience of Lee Callister, independent Web producer. "My impetus for investing (in a particular mutual fund] had to do with the fact that many of the stocks included are technology stocks. I'm familiar with those stocks; I work with technology. So it seemed like a good place to put my money. The fund had a good track record in the last few years and it's been a blossoming time for technology."

As it turns out, the mutual fund that Callister invested in went down substantially a few weeks after he made the investment The lesson here is that when investing, you can't put too much stock (pun intended) into possibilities simply because they're familiar to you. Be sure to substantiate them with further research and professional financial advice. .

Anchoring and When to Break Away
Psychologists tell us that by nature people tend to focus on data that confirms a given belief. So if you believe that investing in U.S. Savings Bonds is the best way to go, you're going to seize on data that supports this idea, be it an article you read online or something that your friend tells you.

Related to this is the concept of anchoring. As the term implies, anchoring refers to being held in a certain position from which you cannot move very far away. It's actually difficult for us to consider external data without being constrained by how it's been presented (framing) and how we've been preconditioned.

For example, a person who grew up listening to his family swap stones about how Uncle Sylvester jumped to his death from a 12th story window during the Crash of '29 is likely to have a protective attitude towards her savings. On the other hand, a person who grew up listening to stories of striking oil on the family farm, winning the lotto, and Aunt Lydia's major gains on the stock market is likely to find investing in high-risk stock a breeze.

Although it's not always easy, you need to be able to recognize when your perception is clouded by the sometimes debilitating constraints of anchoring. What happened to Uncle Sylvester or Aunt Lydia doesn't determine what will happen to us. We need to be able to judge a situation in the present and weigh the factors at hand.

So now that you know what goes into the decision-making process, consider to what extent your financial decisions are a result of framing, heuristics, and anchoring. Work with a financial advisor to help you sort fact from illusion. To an extent our investment personalities are as much a part of our psychological makeup as any other aspect of who we are, but by knowing what causes our behavior, we are empowered with the ability to make decisions based on facts and sound judgment.

lCplanet November 8, 2000