There’s no way around it: market declines are painful. Not only do they shrink your investment accounts, but they also cause a lot of stress and anxiety while they’re at it.
As an investor, these moments tend to inspire that little voice in your head to start getting louder about how you need to do something — something different; something to stop the pain that comes with experiencing loss.
These feelings are usually so strong that it usually doesn’t matter that we have the benefit of hindsight, which tells us making investment changes just to make changes isn’t prudent. This rarely does much to change the presence or the volume of the voice in our heads demanding we take action.
What Soccer Penalty Kicks and Investing in the Market Have in Common
We have to at least try to make the pain stop, right? Everyone feels that desire to do something in response to the discomfort we feel in these situations.
In fact, that tendency is not just normal, it’s instinctive. To understand this further, we can consider the case of penalty kicks in soccer.
With a penalty kick, the goalie has less than a second to react to stop a goal once the shooter strikes the ball. Given this incredibly fast required reaction time, a goalie must decide their move prior to the shooter striking the ball if they hope to have a reasonable chance of saving the shot.
So what’s the optimal position for a goalie? Should they jump left, right, or stay standing in the middle?
The Best Action Is Often No Action at All
Researchers evaluated elite male goalkeepers and looked at the penalty shot distribution of hundreds of shots that they faced. Given the 3 options for goalies of jumping left, right, or staying in the middle of the goal, researchers found that the optimal decision for goalies to stop the most shots was to remain standing in the middle of the goal – not to jump left or right.
Objectively, the best action for a goalkeeper is clear: stand in the middle of your goal. That’s the research-backed, evidence-based way to give yourself (and your team) the best chance of success if your job is to stop balls from going into the net.
But how does that compare to what goalies actually do?
Turns out that goalkeepers jump left or right 94% of the time. Only 6% of the time do goalkeepers choose the action that is statistically proven to give them the highest chance of success.1
Right Incentives, Wrong Decisions
When you consider the incentives elite goalies have to stop penalty kicks, they are abundant. For professional athletes, there are few incentives more powerful than maintaining personal pride and the potential for winning.
But most athletes also have a desire to contribute and to help their team — and it never hurts that success on the field usually equates to better contracts, better endorsements, and better status as a celebrity in and outside of the game.
There’s really no question as to whether or not goalies want to stop penalty kicks. Clearly, they do. But despite strong incentives to do so, they only choose the option that gives them the best chance of success an alarmingly low rate of 6% of the time.
How Pain Avoidance Influences Smart People to Make Questionable Choices
Why do goalies neglect to choose the objectively “correct” response even if they know better? It’s because of the pain they’re looking to avoid.
Researchers found that goalies experience a greater amount of pain from a goal scored following inaction (standing in the middle of the goal) than the pain they experience following action (jumping left or right).
Goalies choose to dive one way or the other because the pain of failure is lessened by action. They make this choice despite that fact that in doing so, they are reducing their chance of a successful outcome!
In other words, the decision is driven by the desire to minimize pain, not to maximize success.
This phenomenon is called action bias — and it should matter to you because goalies aren’t the only ones who suffer from it. Investors are often led astray by the exact same bias.
How Action Bias Could Harm You as an Investor
The study of goalkeepers in soccer demonstrates that action bias exists even in a situation with huge financial incentives to decide correctly (i.e., signing a bigger contract), and where the decision-makers are highly experienced in the decision to be made (professional athletes who specialize in a single technical position).
Action bias can impact you as an investor, too, regardless of how experienced or incentivized you are. Don’t believe it? Think about how often you’ve heard that internal voice telling you, “well we have to do something, anything!” when the market experiences some volatility or stock prices drop.
Investors also feel more pain from losing money when they don’t take any action to try and stop the bleeding. They feel less pain when they lose money if they did something to attempt to mitigate the loss, even if the very action they take reduces their chances of a positive outcome.
How many investors who acted during the Great Recession a decade ago (i.e., going to cash) would have been financially better off in the long run by not acting at all, or doing nothing? Given the bull market of the past 10+ years, I’d venture to say the answer is the vast majority.
Steps to Take to Reduce Your Bias Towards Action
It’s one thing to understand that investors (including you and me) suffer from action bias. It’s another to understand what you can do to fight against it and not let it negatively influence you, which can lead to undesirable investment outcomes.
The first step is creating awareness that all investors – which means clients, financial advisors, portfolio managers, and everyone in between – are predisposed to a bias towards action. Understanding, awareness, and acknowledgement are critical to being able to catch this bias working against you.
Second, investors would be well-served to sit down before the next market decline and create 2 lists:
Make these lists part of your written investment plan so you can reference them during the next market decline as a valuable reminder when your inner voice starts campaigning for action.
After all, you didn’t learn to stop, drop, and roll when your arm was on fire. That mantra was drilled into your mind as a preventative measure. In the same way, it’s critical that you create and know your plan to combat action bias before you need it.
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