Action Bias: To Act Or Not To Act

An empirical study on football penalty kicks shows that goalkeepers tend to premeditate their action before they can observe the direction of the kick. Given the probability distribution of 286 penalty kicks that were analysed, the optimal action for the goalkeeper is inaction, that is, to stay in the centre of the goal. Goalkeepers decide to jump left or right over 90% of the time. The possible reason for this is because the norm is to dive to attempt to save the goal. Norm theory suggests that a goal conceded feels worse for the goalkeeper following inaction than following action, leading to a bias for action.

This same action bias is observed in investing. Investors feel the need to take action based on recent performance; they sell after a bad performance or buy after a good performance. There is a strong tendency to trade after recent losses because we feel less regret when we take action (make a trade or dive to save a penalty kick) and lose as compared to when we do nothing and still lose. The result of the action bias is over-trading. A study from 2000 showed that over-trading had a “tremendous performance penalty”. Their analysis on a large American brokerage firm between 1991 and 1996 showed that investors trading actively made an annual return of 11.4%, while the market made 17.9%. This manifestation of action bias costs investors around 6% of their yearly profit.

Like it is optimal to stand in the centre of the goal during a penalty kick, it is optimal not to make too many trades. However, the desire for a sense of control over a situation leads us to take action which is sub-optimal. This is why 94% of the time, goalkeepers dive to one side or the other because their action shows effort and conceding a goal when an effort is made is not as emotionally painful as when the goalkeeper stands still. Similarly, making trades after a loss is a demonstration of an effort to make good the loss and if there is a loss despite this effort, it is not as emotionally painful as when the investor makes no trades and still loses.

In both cases, the loss does not reflect the lack in the technical ability of the goalkeeper or investor, but the flaw in choice. Investors would be better off being patient and not tracking investments too often; more often than not, short term price movements are emotional reactions to news and not planned financial decisions. We must be aware of our tendency to be passive when we should be active and there are also situations in which it is counterproductive to act.

Sometimes it pays to do nothing