It all boils down to the fact that our view on risk is all wrong. You’ve been taught from a young age that all risk is wrong and immoral.
And what this does is bring up the emotions you have attached to being wrong and bad as a child every time you think of investing.
Because we have all been taught that investing is risky, those emotions cause you stress and anxiety. No wonder you have a fear of Investing.
If you haven’t already, I would strongly suggest that you read my previous posts, “Why am I so scared to invest?” and “Get Over Your Fear Of The Forex Market And Start Investing”, before continuing with this one.
Each situation in life may be viewed from several different perspectives, each producing another way of perceiving a situation. This is called framing, as each situation is considered with a different frame or viewpoint.
Let me illustrate framing by telling you the farmer’s story who could not accept the frames that his neighbours had.
An old farmer was considered well-off by his neighbours because he had a horse, a plough, and a strong son.
But one day, the horse ran off. All the neighbours came to visit and exclaim how unlucky the farmer was. The farmer just said, “maybe”.
Three days later, the horse returned with two wild horses. The neighbours rejoiced at how lucky the farmer was, but he just said “maybe”.
During the next week, when the farmer’s son was trying to tame one of the wild horses, he fell off and broke his leg. The neighbours all exclaimed how unlucky the farmer was, but he just said “maybe”.
That weekend the soldiers came to the village to recruit young men for military duty. When they saw the farmer’s son with his broken leg, they rejected him. The neighbours knew that the farmer was lucky, but he just said, “Maybe….”
This story illustrates that the most widely held frame (buy crypto), the one usually held by most of your peers, is not necessarily the correct one. Some common frames can be disastrous for investors.
These are the frames that support the Loss Trap:
The Loss Is Not A Loss Frame
Many money decisions involve a loss, framed as something else, making it seem less painful or even acceptable. A $600 insurance premium is a sure loss, but most of us don’t consider it as such.
You might even argue that it is not a sure loss compared with a $10,000 accident bill that you may receive.
But that argument really supports the frame. The insurance company may pay your bill, but you won’t get the $600 back. You have just limited your loss to $600, and that is still a sure loss.
And any insurance is a prime example of the loss is not a loss frame.
How does it apply to Investing? Consider this following decision and answer with what best describes your feelings.
Would you find a $200 expense acceptable if it gave you a 60% chance to win $350 and a 40% chance of no gain? Do you feel that this is an acceptable risk?
Would you take a risk that gave you a 60% chance to win $150 and a 40% chance to lose $200? Is this an acceptable risk?
Which decision did you find more acceptable?
You may have decided that decision one was an acceptable risk. After all, you could win $350, and you would not lose anything but your expenses.
Investors commonly make decision one.
How did you feel about decision two? Perhaps it did not seem as good. You only had a chance to win $150, and you could lose even more. Losing more than you win is not that acceptable.
If you are like most investors, you will have found decision one more acceptable than decision two.
But if you closely at the two decisions, you can see that they are mathematically the same. The apparent difference is that the loss is framed as an expense in decision one and framed as a loss in decision two.
When the $200 in expenses is considered as a loss – and it is a loss – the $350 gain becomes $150 gain, and no gain becomes a $200 loss.
Suppose you realized that they were both equivalent congrats. Hopefully, you are just as wise when real money is at stake.
The Percentage Frame
Framing is also important with respect to the cost of an item. Many people will drive across town to save $5 on the price of a $20 article of clothing. They, however, wouldn’t dream of driving across town to save $5 on the cost of a $500 appliance.
Yet the saving is the same, and the cost of driving across town, which is probably more than the $5 in savings, is precisely the same.
Somehow the added miles and time seem to worth a 25% saving but not worth a 1% saving, even though both savings are $5.
As a result, high ticket items have a lot of pricing variability between stores because people are much more concerned with the percentage saved than with the actual dollar amount. This is the percentage frame.
The percentage frame is important to investors.
You’re more likely to tolerate a $500 loss on a $10,000 account which is 5%, than a $500 loss on a $2,000 account which is 25%. Before swap costs are figured into each loss, the two losses are equivalent!
The dollar amount is the same, but one loss you could tolerate while the other you couldn’t.
Don’t Make This Mistake
The loser with large losses can use the percentage frame to turn his losses into a catastrophe. For example, consider someone who has a 5K loss that appears to have bottomed out.
He is quite willing to risk a few hundred dollars more, which he perceives as his maximum risk because he believes it is at the bottom to recover his money.
This small risk seems even more attractive, and the bottom appears even closer because the percentage frame becomes more effective. The percentage frame, as a rule, allows losses to grow.
All types of investors apply the percentage frame to their investing strategy. They do so by failing to see a losing strategy as a losing strategy.
An investor may have lost $100,000 over three years, leaving only an emergency fund of 5K. When the 5K is framed against the 100K, it seems poultry.
As a result, the investor is willing to risk his last 5k in a desperate attempt to make back his losses. Even this act of desperation may not end the loss trap, as some investors go heavily into debt before they finally let go…
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