Revenue Recognition and Framing

Feb 25, 2007 by

Imagine two investors: A and B. A bought some XYZ stock for $2,000, sold it when it went to $3,000, and then rebought it a month later, after the price remained at $3,000. B bought some XYZ stock for $2,000 on the exact same day that A initially bought it. He held the stock, and his shares are currently worth $3,000.

Thus, A and B both currently have $3,000 worth of XYZ stock that they acquired by investing $2,000 over the same amount of time. However, A and B may feel drastically differently about their investments.

A’s online portfolio tracker says:

Stock: XYZ Holdings Value: $3,000 Gain: $0

B’s online portfolio tracker says:

Stock: XYZ Holdings Value: $3,000 Gain: $1,000

Now, imagine that there was a slight market downturn, and shares of XYZ dropped 10% in price. Here is what the portfolio trackers would say after this event:

A’s online portfolio tracker says:

Stock: XYZ Holdings Value: $2,700 Gain: -$300

B’s online portfolio tracker says:

Stock: XYZ Holdings Value: $2,700 Gain: $700

So, investor A feels like he lost $300, while investor B can console himself that at least he has made $700! Upon seeing this, investor A is far more likely to want to cut his losses and sell XYZ than investor B, as he is focused on the loss, while investor B is focused on the gain.

What does this mean for the average investor? Always consider the effects framing may have on your investment decisions. Lots of people like to rapidly get in and out of the market. By doing so a little, they may induce themselves to do so even more, as they fail to attribute their long-term capital growth to their current investment. When investing, the price at which a stock was purchased should be irrelevant in your decision whether or not to sell a stock. Nonetheless, people psychologically are more likely to sell stocks if they purchased them at a price slightly above the current price. By buying and reselling a stock, you reframe the value of the stock as being the price at which you repurchased it. This gives you less of a mental buffer for downswings in the market.

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6 Comments

  1. wow… you rock, adam. I just subscribed to this.

  2. Hi. Interesting blog. I am only young but have long been interested in finances. I like the blog. Not sure I quite followed the story too much but I understand the point you are getting at. Buying shares and selling them does seem fun, but as your story in another way showed, it can make you win or lose. I certainly wouldn’t do it unless I had the money to spare. Hope you don’t mind a bit of constructive criticism – the story could be made a bit simpler :)

  3. Heather P.

    Wow – I have not gotten into investing in stocks yet just because it seems overwhelming. Reading your explanation of framing makes it even more intimidating in one way. It seems like it would be difficult to trust your investment broker; not that they are lying to you, but it appears that they could manipulate you depending on how they presented the information to you. This was a great heads up for someone thinking about dipping their toes into the investment water.

  4. this is interesting advice. i recently got involved in stocks and i made the mistake of backing out too soon. i’ll keep this in mind for next time.

  5. I’m a forex trader. In the foreign currency trading, we also can meet the similar situation. I always said that, in the transaction, find the trend is in all matters simplest, it is the most difficult to control emotion. A person may through the study, grasp the main point of the technical analysis, but the ability of emotion control, actually is and person’s inborn and it is to change. Said from this point, perhaps succeeds is inborn.

  6. Scooby

    As with many facets of modern life, emotion plays an important role in investing. Some would argue that logic is the ideal guide to smart investing, but they would miss an important consideration.

    It is only through a balanced approach to investing, weighing the technical fundamentals with other, non-technical variables, that we can differentiate ourselves from the computer-driven institutional trader.

    Your examples show ways in which the emotional side of our investing muse can be misled. Keep your eyes on the prize.

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