The framing effect matters in currency hedging decisions (and in lots of other investment decisions, too)
The framing effect is the tendency for people to perceive similar outcomes differently, depending on how they are framed. It is hard for institutional investment programs to completely avoid this effect. Consider currency.
A currency loss? Or just a missed opportunity?
The Russell Developed ex-US Index returned an annualized 8.5% over the 4-year period to the end of August, 2015. But the currency-hedged version of the same index delivered 15.4%—almost 7% a year extra.
Most U.S. institutional investors do not hedge the currency exposures in their international equity portfolios, so they missed out on that extra return. Of course, missed opportunities are everywhere in investment, and few investors are losing sleep over the opportunity cost of not hedging over that period.
But now imagine that a different set of circumstances applied: suppose that this had not been a period of dollar strength but rather a period of dollar weakness (like 2002-2004 was, for example.) And suppose, too, that an investor had decided to hedge their currency exposure, resulting in a currency loss of almost 7% a year. The reaction to that loss would most likely be very different from the reaction we have seen to the missed opportunity that arose from not hedging—even though the financial effect is the same.
The different reaction arises because the first case is an opportunity cost, while the second is a realized loss. The “default” decision is perceived as being the unhedged position—and a loss that arises from a deviation from that default position hurts more than a loss that arises from sticking to it.
The framing effect
This is an example of the framing effect—how we perceive an outcome depends on how it is framed.
Currency hedging is an interesting example, because it’s not clear that the unhedged exposure really should be perceived as the default position. The reason that it is so is probably some combination of (a) early allocations to international assets were small and (b) currency hedging used to be far more expensive and inconvenient than it is today—so historically it wasn’t considered worth the effort of hedging currency exposure. And that historical precedent has stuck.
But it’s not my intention here to get into the rights and wrong of currency hedging—rather, to make the point that the framing effect has a significant practical impact on investment decisions.
The framing effect applies in many other situations, too. It affects how the results of other hedging decisions are judged, not just currency hedging. It affects how non-profit organizations respond to peer group behavior. It makes it easier for defined benefit plans to take massive bets on interest rates and equity markets. It can discourage defined contribution plan fiduciaries from taking active positions that are likely to add value.
The net result of the framing effect is that some investment strategies are given a much easier ride than others—less likely to be called into question, more time to work, less angst should they fail.
Dealing with the framing effect
Ideally, all investment decisions would be made purely on the grounds of what is most likely to help achieve an investor’s objectives. So the framing effect has the potential to undermine the investment process, either through unequal treatment in how outcomes are judged or by causing more-favorably-framed decisions to be made in the first place.
Unfortunately, recognizing that the framing effect exists does not make it go away. It can be possible to reduce its effects by managing stakeholder expectations, and it’s often worthwhile doing so. But that only works to some extent; the perceived default tends to remain the perceived default no matter what is said at the time a decision is made. So, as is often the case, the best response is not so much about suppressing the natural behavior, but rather about building a decision-making structure that minimizes the damage.