second source of utility in Eq. (11), or in short, on b 0. As a way of thinking
about this parameter, BHS note that when b 0 =0.7, the psychological pain
of losing $100 in the stock market, captured by the second term, is roughly
equal to the consumption-related pain of having to consume $100 less, cap-
tured by the first term. For this b 0 , the Sharpe ratio of the risky asset is
0.11, about a third of its historical value.
BT and BHS are both effectively assuming that investors engage in nar-
row framing, both cross-sectionally and temporally. Even if they have many
forms of wealth, both financial and nonfinancial, they still get utility from
changes in the value of one specific component of their total wealth: finan-
cial wealth in the case of BT, and stock holdings in the case of BHS. And
even if investors have long investment horizons, they still evaluate their
portfolio returns on an annual basis.
The assumption about cross-sectional narrow framing can be motivated
in a number of ways. The simplest possibility is that it captures noncon-
sumption utility, such as regret. Regret is the pain we feel when we realize
that we would be better off if we had not taken a certain action in the past.
If the investor’s stock holdings fall in value, he may regret the specific deci-
sion he made to invest in stocks. Such feelings are naturally captured by
defining utility directly over changes in the investors’ financial wealth or in
the value of his stock holdings.
Another possibility is that while people actually care only about
consumption-related utility, they are boundedly rational. For example, sup-
pose that they are concerned that their consumption might fall below some
habit level. They know that the right thing to do when considering a stock
market investment is to merge the stock market risk with other pre-existing
risks that they face—labor income risk, say—and then to compute the like-
lihood of consumption falling below habit. However, this calculation may
be too complex. As a result, people may simply focus on gains and losses in
stock market wealth alone, rather than on gains and losses in total wealth.
What about temporal narrow framing? We suggested above that the way
information is presented may lead investors to care about annual changes
in financial wealth even if they have longer investment horizons. To provide
further evidence for this, Thaler, Tversky, Kahneman, and Schwartz (1997)
provide an experimental test of the idea that the manner in which informa-
tion is presented affects the frame people adopt in their decision making.^18
In their experiment, subjects are asked to imagine that they are portfolio
managers for a small college endowment. One group of subjects—Group I,
say—is shown monthly observations on two funds, Fund A and Fund B.
Returns on Fund A (B) are drawn from a normal distribution calibrated to
mimic bond (stock) returns as closely as possible, although subjects are not
given this information. After each monthly observation, subjects are asked
A SURVEY OF BEHAVIORAL FINANCE 29(^18) See also Gneezy and Potters (1997) for a similar experiment.