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Monday 12 February 2018

Bias In Action

Myopic Urges

The recent sharp correction in markets has clearly surprised a lot of investors. No doubt this is partly due to the standard myopia people seem to exhibit as soon as the last crash is out of sight, but it also seems to be connected to the fact that the seemingly inexorable rise in share prices and the continuing low interest rates on deposits has tempted new people into stocks. Faced, for the first time, with nasty losses they’re casting about for some kind of strategy to deal with the situation.

In truth if you need to find a strategy after markets have started falling it’s too late. For most of us the only sensible approach is to only buy things we’re comfortable holding through any kind of downturn and to then do nothing when volatility strikes. But even experienced investors face the urge to do something – anything – in the face of mounting losses. This is action bias, in action.

What |Goes Up ...

Corrections – 10% market falls – are not uncommon. The S&P500 suffered, on average a 10% fall about once every 3 years or so from 1926 up to 2015. This is not a rare event, and the idea that the average investor can somehow time their way around these occurrences is a nonsense. Frankly most professionals will call a significant number of these wrong, and the only people who will call them correctly 100% of the time are the people who are bearish 100% of the time.

Despite this people will tend to be caught by surprise by these kinds of falls. This is particularly true after long periods of low volatility, where they become lax about their buying criteria. If all share prices ever do is go up it’s easy to be lulled into forgetting that you’re just on the level section of the rollercoaster. Share price falls cause psychological pain and anxiety, the flight or fight reflex encourages people into action and, all too often, when investors don’t know what to do they take refuge in herding and appeals to probably false authority.  As so often, behavior that was perfectly adapted to a life in pre-industrial times is perfectly wrong in the stock market.

Straight Down The Middle

Analysis of football (that’s soccer for American readers) goalkeepers facing penalty kicks reveals the problem. It turns out that goalkeepers dive to the right or the left 94% of the time. They guess correctly 40% of the time and save about a quarter of the correct guesses. It turns out that if the goalkeepers didn’t move at all their chances of saving the penalty increase from 13% to 33%.

Now elite goalkeepers have every reason to save penalties, but they choose a strategy that basically ensures they have a lower success rate. The underlying research paper postulates that this is action bias, in action:
We propose the following explanation for this behavior: because the norm is to jump, norm theory ... implies that a goal scored yields worse feelings for the goalkeeper following inaction (staying in the center) than following action (jumping), leading to a bias for action.

Let’s face it, if you do nothing and the kicker rolls the ball into the side of the net you look pretty stupid, while a spectacular dive always looks good even if the ball goes the other way.

Strategically Active

This is action bias – faced with a choice we very rarely choose to be strategically inactive. It’s the same issue we face when we end up in a traffic jam – people dive off down side roads, get lost in industrial estates and annoy sleepy neighbourhoods by randomly charging around. Usually waiting for the jam to clear is the best option – but that means doing nothing, and that’s hard.

The same researchers postulate that the bias can affect investors:
For example, the action/omission bias might affect the decision of investors whether to change their portfolio (action) or not (inaction). It can affect the choice of managers whether to leave their company's strategy or investments unchanged (inaction), or to change them (action).
In stressful and complex situations, such as when markets fall sharply and start to bounce about like a manic depressive on a trampoline, doing nothing is often a sensible option. However, this is only an option if you’re positioned to be able to do so. If your favoured investments are blue sky, sentiment driven stocks then probably your best bet is to try and sell them – although most likely you’ll struggle to do so. Similarly, if you’re using gearing and aren’t hedged then getting out fast is a better option than hanging on.


The problem is that markets may recover quickly – or they may carry on falling. Despite the vast volumes of opinions published by both professional and private commentators the truth is that markets are inherently unpredictable. Putting yourself in a position where you have to sell in the face of a downturn is profoundly irrational.

In fact, in general, masterly inactivity in the face of market jiggery-pokery has turned out to be a successful strategy. A post by Weston Wellington – Should Investors Sell After A Correction? – shows the market returns following 5% and 10% falls between 1929 and 2015. On average the S&P500 and international large cap stock markets bounced by 24% in the following year. Emerging markets bounced on average by 42%. All markets went on to provide above average returns over 3 and 5 years.

Be Ready

Of course, realising this strategy relies on a couple of things. Firstly you need to have the courage to ride out the correction, even adding along the way. Secondly you have to be invested in the right things. Oh, and being heavily diversified helps as well: some otherwise fine companies will be exposed if capital markets shut on them, it isn’t always easy to spot them ahead of time.

As usual, the rule of thumb is to have a plan. If you go into a correction without one then the best thing you can do is stick tight, although if you’ve bought a bunch of sentiment driven small cap indebted shares you’ll probably not have a happy outcome in any event.   Be prepared, always, for a downturn because there’s always one just around the corner.

Action bias added to the Big List of Behavioral Biases

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