Millions of years ago, humans recognized that taking action is essential for survival. This instinct had been deeply hardwired and ingrained in human evolutionary development. In modern worlds, some things have changed that we may have to adapt accordingly. This is very true with the nature of investing and especially algorithmic trading.

Let’s start with some real life example:

You are the goalkeeper in the World Cup Tournament. You are facing an important penalty in which you have to choose 3 options: jump left, jump right or stay still in the center. It’s very common that you will either jump left or right and not stay still in the center. However, remaining centered statistically helps increase the chance of successfully catching the ball. Why did it happen?  

Let’s see it from the audience view of point:

The decision of jumping regardless of the outcomes in both cases often leads to better results than staying still. This motivation compels goalkeepers to dive, even though statistically, remaining stationary would increase the chance of success. This scenario serves as a classic example of action bias.

Action bias is the psychological phenomenon where individuals prefer taking action over inaction, even when no evidence suggests that doing so would lead to a better outcome.

Action Bias in Investing

In the realm of investing, if an investor examines the news, charts, or price movements, then soon enough, a question would follow: what action should I take next? Various scenarios play out in the investor’s mind, though the fear of missing out on a new opportunity or seeing profits turn into losses or anything else ultimately will drive them to make a decision: DO SOMETHING.

What investors will do may include rebalancing their current portfolio, acquiring new stocks, changing margin proportion. Little did they know, without real strong evidence, many of these actions are a waste of time, energy and money due to transaction cost and opportunity costs.

Let's make it short, naive investors would have more than 95% chance of underperforming the market index over time because of the attempt to “maximize profits”. Perhaps, that‘s why the popularity of passive investing strategies has gained much traction lately.

Action Bias in Algorithmic Trading

Algorithmic trader is the one who needs to guard themselves most from action bias. Let’s start with four reasons why algorithmic traders are particularly motivated to take actions.

First, as an algorithmic trader, one must have very high awareness of the market. Being an expert in this field may lead to a high level of confidence in trading decisions. Sooner or later, the trader will have some trading ideas. Some may make new trading ideas on a daily basis. This should make a lot of sense to do something in light of so many perceived good trading ideas.  

Second, a high-level algorithmic trading approach will minimize manual intervention. Zero interference policy is a must to stabilize the trading system. A trading expert in financial markets with zero trading activity allowed seems very counter intuitive. This will make executing some action or changing some configuration in the system very tempting.  

Third, financial markets can offer substantial rewards to traders who make the right decisions within a short time frame. The allure of becoming “rich” or “successful” in just one or two actions is absolutely captivating for an individual, even for a high-level intellectual person.

Lastly, algorithmic traders have access to powerful trading tools that enable them to execute strategies beyond what discretionary traders can achieve. This advantage may lead to excessive utilization of these tools, driving lots of actions.

These underlying reasons may drive the psychological state of an individual to take some actions even though it is going against the carefully designed system for optimal results. The results for some interference are hard to evaluate though in many cases it will be counterproductive by reducing performance, compromising data integrity and incurring higher costs.

At Algotrade, we believe guarding yourself against action bias is very important as an algorithmic trader.

How to Reduce Action Bias

Be rational and opt for the long-term best option for the priority target. In case of the goalkeeper, one’s psychology can determine the action of “not jump” if his thinking model as of follow:

Also, keep in mind that inaction is a real valid option in the modern world. When uncertain, taking action without understanding can lead to excessive costs without results. Inaction by choice is a very high intellectual choice that can be made by experts and totally different from inaction by default which is labeled frozen or lazy. The later will undoubtedly only bring bad results in the long term while the former may bring you to the next level of expertise. A small note that one individual always needs a way to release energy by some specific actions, thus choosing inaction in some areas may need some actions in other areas. The optimal choice will make the better outcomes in both fields.

Ultimately, don’t be tamed by irrational behavior without root cause. You have the power to learn and adapt to guard yourself from your instinct of “doing something”. This process takes time but it is very well worth it if you ever choose a career path in investing or algorithmic trading specifically.