Remember those optical illusions that used to tease you as a kid? Is it an old woman or a young woman? Is it a vase or two faces? Or anything by Escher?

In each of these cases, we have two contraries existing simultaneously. The one you see depends on the one you’re looking for. There’s no way to empirically prove the existence of one while denying the other. It all depends on how you frame the picture.

What works in art also works in finance. We think Modern Portfolio Theory tells us there’s a relationship between risk and return. That’s how many see it.

In fact, while this relationship might exist on the blackboard, it doesn’t exist in the real world.

The real world tells us that it is “perceived” risk that’s related to “expected” return. These qualitative factors have greater influence than the quantitative figures we falsely imagine rule our lives.

For example, you might think the market falling 1,175 points on Monday, February 5, 2018 might have offered an excellent lecture in classic economics. Okay, maybe it did. Or did it?

Sure, a rising economy begets inflation which begets higher interest rates which increase the cost of capital which changes valuation parameters on equities. This is, after all, classic economic theory.

This, however, is not what happened on Monday, February 5, 2018. What changed was our expectation that this will all happen very soon, (see “A Fundamental Economic Fact Fiduciaries Use to Fight Fear of Falling Markets,” FiduciaryNews.com, February 8, 2018).

The more compelling teachable moment, on the other hand, lies not in classic economics but in behavioral economics.

No sooner had the market closed than it was “Let the lesson begin!” The mass media trumpeted the free falling market like the Weather Channel hypes winter storms. Only, instead of highlighting potential snowfall numbers, we had the actual points lost on the Dow.

Reporters framed the story to extract the maximum emotional response from their audience. Did you see them?

They accurately declared the 1,175 point drop at the biggest point loss in the history of the Dow Jones. It far surpassed the previous record – the TARP inspired 777 point loss on September 29, 2008.

If you recall that time period, it represented the onset of the credit crisis that virtually froze our economy.

This is the kind of imagery editors love. You’ve got easy-to-understand numbers packaged in a blaring headline that implies a catastrophic event. It’s got click-bait written all over it. Almost every media outlet chose to frame the day’s events in this manner. And it worked.

Except it didn’t.

You see, this was only one side of a prototypical optical illusion. The opposite frame ignored the points and focused on the percentage drop. The market lost a total of 4.6% on February 5, 2018. Compare that to the 7% drop on that fateful September day in 2008.

In fact, according to the Wall Street Journal, the 4.6% fall managed to merit only the 99^th worst single day fall in Dow history.

Number 99. That’s not a headline-grabbing number.

That’s why editors didn’t run with it. Who reads that story? Who freaks out reading that number?

Who’s going to make a rash knee-jerk decision based on the “99^th worst” day on Wall Street?

Oops. It’s that last question that suggests the meaning of this lesson in behavioral economics.

The same data can be presented in two equally opposing ways, much like an optical illusion. Which view we see can determine our emotional response. This, in turn, can influence our decision-making process.

If we want people to get upset and potentially take actions that might harm them, print the headline that trumpets the “worst point drop in history.”

If we want people to ignore what amounts to nothing more than a standard “blip” in the market, then we lead with the “99^th worst percentage loss” headline.

Performance reporting is rife with optical illusions like this. Short-term numbers that emphasize volatility scare investors into making improper long-term investments. Benartzi and Thaler showed this in their research two decades ago.

Why is it so hard to learn this lesson?

Instant Insights /

Live from Wall Street: behavioral finance in action &ndash; Carosa

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