What is Action Bias - and what does it mean for investors?
There are many behavioral biases that impact our success as investors, and one of the more impactful ones is Action Bias. In this article, we’ll discuss what action bias is, and how it impacts investment decisions.
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What is action bias?
There is a psychological flaw called action bias derailing investment decisions people make; it is the belief that taking action is better than doing nothing. It has far-reaching effects on our behavior as investors. Usually, action bias kicks in when there is an event that has transpired, and it either surprises us or makes us feel we have suffered some sort or loss (or that we are about to). Our response often times is to take action without considering if it is really the best thing to do.
To quote The Decision Lab:
The action bias describes our tendency to favor action over inaction, often to our benefit. However, there are times when we feel compelled to act, even if there’s no evidence that it will lead to a better outcome than doing nothing would. Our tendency to respond with action as a default, automatic reaction, even without solid rationale to support it, has been termed the action bias.
The flaw of action bias is innate to human beings. It makes us feel better when we feel we are in control of outcomes. This feeling of esteem reinforces the behavior. It’s almost as if it is ingrained in our psychology.
How Action Bias impacts investing: an example
How can action bias influence the investment decisions a person makes? Action bias is one of the many biases of behavioral finance which is the study of the effects of psychology on investor behavior. In some cases, action bias can lead investors to make bad investment decisions.
Let’s say that you sitting there watching the news one day, and you see that all of a sudden one of the major world powers has invaded their neighboring country. “A war has broken out!” scream the journalists. A feeling of panic starts to take hold.
It’s a natural instinct to log on to your investment accounts and monitor the situation (way more periodically than you normally would). You may even feel compelled to contact your financial advisor for advice about what to do. They’ll probably tell you that staying the course is the best answer, but you may second guess them. You might even go against their advice and panic sell (which is usually not a beneficial long-term outcome).
Every investor should have a long-term plan, and a mechanism that prevents them from derailing it by doing something just to “take action.” To accumulate wealth long term, it is best that action bias (as well as other behavioral biases in finance) be managed.
When and how to choose inaction in investing
How does an investor overcome behavioral finance biases – in this case, action bias? It’s difficult to do on your own, when you are constantly assaulted by an onslaught of provocative information from the 24/7 media and news. How does someone overcome investing action bias and choose inaction?
- As with any behavioral finance bias, recognition of that you are subject to action bias is the first step. It can be hard to admit; we’re naturally going to be overconfident of our abilities as investors – that is a bias that we tend to have.
- Action bias can be “unlearned” so to speak by implementing controls, such as financial plans, checklists, psychological calming techniques, meditation, and routines that help you resist impulse. For example, consider a “three hour” rule whereby you set a timer that goes off, signaling it’s okay to check your portfolio. This will avoid compulsive portfolio monitoring.
If these techniques are ineffective in controlling your bias to taking investment action, it may be best to consider outsourcing the management of your portfolio to an objective third party such as a fiduciary financial advisor.
Behavioral coaching
The psychological tendency we call action bias is just one example of the cognitive inclinations that investors have. Emotions cause investors to make all sorts of mistakes such as:
- Performance chasing
- Speculative euphoria
- Panic selling at market bottoms
It is our belief that in the long term, the investor’s behavior is what drives returns far more than the performance of investments. Most investors underperform the market due to the behavioral biases they are subject to.
A good financial advisor is able to remove emotion from the equation, helping the investor to be less subject from other investing biases such as:
Anchoring bias
Confirmation bias
Disposition bias
Familiarity bias
Loss aversion
Self-attribution bias
Trend-chasing bias
Together with your financial advisor, you can set goals, assess risks, and follow a disciplined strategy. One of the most important roles that a financial advisor plays is helping to contain any emotional investing behavior. Having a behavioral investing coach allows you to make objective, rational decisions that will hopefully benefit your wealth creation in the long term.
So how do you find a good financial advisor?
Thanks for reading our blog about investing action bias and how to overcome it - we hope it was useful.
Need some help curtailing your bias to action when it comes to your portfolio? We’ve written other blogs about how to find a financial advisor, what financial advice costs, and the perks of working with a financial advisor. We hope you’ll enjoy reading them, should you so desire.
We are a fiduciary financial advisor in the Philadelphia, PA area, but we work with clients across the country. We provide fee-only, objective advice to our clients on taxes, wealth management, and financial planning. If you would like to discuss a possible relationship, contact us.
Sources
The Decision Lab. Why do we prefer doing something to doing nothing? The Action Bias, Explained. Retrieved on March 5th, 2022 from here.