Volatile markets have the potential to unnerve many, but there is good reason why you should avoid acting impulsively and instead remain patient to stop yourself from becoming an ADHD investor.
We recently touched on the importance of acknowledging, respecting and embracing uncertainty in the market, however, there is another element we all too often neglect when it concerns investor mindset and psychology - fear.
Humans have a tendency to be scared during times of uncertainty, especially when it comes to things that we cannot control. A falling market is just one example. This is a phenomenon that is in many respects conditioned into us as part of the fight or flight response, which is an automatic physiological reaction to an event that might make us anxious, concerned or fearful. It was evident thousands of years ago in our ancestors, and it is still on show today.
We witness this response in many aspects of our day-to-day lives, yet understandably, we might not be cognisant just how much impact this can have on our decision-making. That’s why it is important to understand how fear can shape not just our own behaviour, but also other investors in the market. After all, our emotions can get the best of us at times, and as humans we are prone to changing our minds and acting inconsistently based on our emotions and perceptions that all risk is bad.
Fear can lead to action bias
When we talk about the role that fear has on investors, our conversation should centre on a phenomenon that is referred to as ‘action bias’. This is our tendency to favour actions over inaction, even if there is no particular rationale to support an action being made in a specific situation.
You might describe it as our conviction that taking action will help us feel better where acting and not acting would result in the same outcome. For example, think about a time you have been stuck in traffic and decided to try an alternative yet less familiar route in order to try to cut down time.
Fear is a major driver of action bias. When dealing with losses, the urge to reach for an action bias is exceptionally high. Consider a period of heightened volatility in the market. Naturally, many investors feel compelled to take action to prevent losses from compounding.
In the minds of many, it is better to make a decision to try to do something to reduce our fear. However, that often might not be the best course of action given the emotions tied to those decisions and the general tendency for the market to climb higher over time.
There is a misconception that action bias is a sign of inexperience. We are all vulnerable to this human tendency, typically because we can immediately see the impact or result of a decision we make as opposed to waiting for an alternative course of action to play out. An onus of responsibility can also make us feel as though we need to take action in order to justify our decisions to those around us, particularly those who trust us.
The hazards of action bias
To understand why action bias can be so harmful for investors, we need to acknowledge that as humans, our emotions play an influential role in the outcome of poor investment decisions.
Let’s consider an example from outside the investment universe, albeit one that still relates to every decision you make in the stock market. The analogy comes from a book written by behavioural finance author and analyst James Montier, ‘The Little Book of Behavioural Investing: How Not to Be Your Own Worst Enemy’.
In Montier’s book, he touched on the behaviour of football goalkeepers when facing a penalty kick. He noted that goalkeepers would dive one way or the other 94% of the time, however, research suggested that the best outcome for the goalkeeper was to refrain from diving and stand their ground in the same spot in the middle of the goal.
Why would goalkeepers make a decision that wasn’t inherently backed up by data? As humans, goalkeepers felt as though they were compelled to be seen making a decision to actively do something. That is, move either left or right. However, inaction and standing one’s ground is a deliberate and conscious choice based on a strategic decision, even if it might not appear like such to those looking on.
If we relate this back to the stock market, it should be apparent why investors can fall into a similar trap. That is, action bias can often lead to investors either over-trading or missing out on opportunities. Montier noted from his studies that “fear causes people to ignore bargains when they are available in the market, especially if they have previously suffered a loss. The longer they find themselves in this position, the worse their decision-making appears to become.”
Meanwhile, investors may feel compelled to trade for a number of reasons when the best course of action might be to do nothing. Think about a time where you saw the market falling and you felt as though you should sell your shares. Alternatively, you might recall a time where you decided to chase the next ‘big’ trend or thematic. Perhaps you haven’t placed a trade for a while and feel as though you should make up for ‘lost’ time. All of these are examples of action bias, and the impact can be significant.
If you are trying to beat the market by actively trading, you introduce more risk and also lose a portion of your earnings on every trade through transaction fees. Historical data points to underperformance among many active traders, while staying ‘long’ often yields superior returns.
How to combat action bias
Action bias is one of many behavioural biases that can have an impact on the performance of our investment returns. The idea that we can just eliminate this bias overnight is a fallacy, however, we can take steps to ensure that we are equipped with the mindset to manage action bias.
The key point is quite simple - patience. Obviously, each of us knows this is easier said than done. Having the discipline and self-control to prevent oneself from making an impulsive action doesn’t come naturally, so this is often a skill that must be learned. Again, Montier summed this up best when arguing “patience is a weapon you can use to stop yourself becoming an ADHD investor”.
We should know from some of the most-successful investors of all time, including Warren Buffett, the buy-and-hold strategy is a proven approach to do well in the market. You don’t need to trade just for the sake of trading, and if you are forcing it, something is likely awry.
Warren Buffett is also someone that believes in playing to your strengths. He would frequently draw on another sports example, this time baseball. The book titled ‘The Science of Hitting’ written by the famous Boston Red Sox player Ted Williams, who laid claim to one of the highest batting averages in the game.
The secret to Williams’ success was only swinging at balls that fell into his ‘sweet spot’. This zone was where he felt best-equipped to hit them out of the park. Williams’ patience meant he would wait for the right opportunity to come up, and only then would he take action. He didn’t waste energy on a play that was of lower probability. This is something we need to consider in the investing universe. We should avoid investing just for the sake of it because we have cash on hand.
If you want to make it easier to accommodate action bias in your investing journey, refocus your goals. It is important to recognise what type of investor you are and how you manage your emotions. Recognise your true risk profile, your tolerance to risk, as well as your preferences and progress as far as your financial goals.
The impact of this is to help you reach a better position where you can take a step back, reflect on the situation, and then focus on the important aspects at hand. It is far better to take the time when reacting to a situation than jumping in with both feet. This will prove invaluable in the future when market volatility and pullbacks inevitably happen again.
While a volatile market can be a confronting challenge for investors to navigate, we can’t let our fear dictate the decisions we make, nor the actions we take. Action bias is one of many behavioural biases that we can fall victim to in the stock market, and it can have a detrimental impact on our returns.
No matter your investing style, if you allow fear and action bias to have an influence over your mindset, you are no longer investing rationally but rather, emotionally. This is the moment where investment returns can be compromised by over-trading or impulsive decisions that don’t align with your plan and goals.
Remember, there is no need to be active in the market just for the sake of it. Patience and discipline are arguably the most fundamental mechanisms to combat action bias and deliver consistent returns over time. So the next time you think about whether you are trading often enough, ask yourself, is the ball in your sweet spot?
Have a great week,
George Wong - Certified Financial Planner