Financial Decision-Making in Action

By Alain Samson, Ph.D.

 

The most frequently encountered real-life application of behavioral economics is undoubtedly that of automatic enrollment into retirement savings plans. These programs simply set the default to ‘contribute’ and let human inertia take its course. They produce good results due to default bias, people’s tendency to passively go with options that have been preset for them. Indeed, people’s propensity to do nothing is an important insight of behavioral and decision science and touches on a range of issues from status quo bias (e.g. a failure to switch to a better insurance plan) to the sunk cost fallacy (e.g. continuing a fruitless endeavor because we’ve already invested resources in it).

In some situations, inaction is the result of anticipated regret. Consider the following scenario:

Nancy owns shares in Company A. During the past year she considered switching to stock in Company B, but she decided against it. She now finds that she would have been better off by $1,200 if she had switched to the stock of Company B. George owned shares in Company B. During the past year he switched to stock in Company A. He now finds that he would have been better off by $1,200 if he had kept his stock in Company B. Who feels more regret?

According to research on the action effect, George should be more upset than Nancy. This happens because it’s easier for George to imagine not taking an action (and thus keeping the better stock) than it would be for Nancy to imagine taking the action. In anticipation of regret, people should generally favor inaction over action.

Now consider an entirely different scenario:

You’ve just been diagnosed with an acute illness. Your physician tells you that there is currently no cure. Actually, there is a treatment, but clinical trials have found no significant difference in outcomes for people who were given the treatment vs letting the illness take its course. What will you do?

If you’re like most people in this situation, you’ll probably at least consider taking the treatment, regardless of the lack of clinical evidence for its effectiveness. It’s human to feel an urge to act in order gain a sense of control over the situation and eliminate the problem. This has been termed the action bias.

There are some situations that involve uncertain outcomes in which the desire act should be strong:

  • Action norms. If we either do something for others or are expected to act, our impulse to take action should be greater. There is a famous study about soccer goalkeepers who tend to jump to left or right on penalty kicks, even though statistically they would be better off if they just stayed in the middle of the goal. In finance, the same action bias can occur in environments where frequent action is the norm, such as among day traders.
  • Prior negative outcomes. Imagine you were enrolled in a default retirement fund through your employer, which ended up producing negative returns. A year later, you’re given an opportunity to change funds. Regret theory suggests that you would now be more compelled to take action (i.e. less susceptible to the default bias), as inaction would be a failure to do something to improve the situation.
  • Overconfidence. Individuals with excessive levels of confidence are more likely to think that they can affect outcomes through their own behavior. In the world of investing, for example, overconfident individuals often tend to trade too frequently for their own good.

In order to improve our financial decisions, it’s important to be aware of both our tendency to be passive when we should be active and situations in which it may be detrimental to act. Sometimes it pays to do nothing.

 

Alain Samson
Alain Samson, Ph.D., is the founder of behavioraleconomics.com and Chief Science Officer at Syntoniq.
Alain Samson
By | 2018-03-27T14:28:22+00:00 March 27th, 2018|

One Comment

  1. Helen March 28, 2018 at 1:39 pm - Reply

    Thanks for this piece. It’s never too early to start saving for retirement – my son’s first job as a camp counselor was last summer when he was 16. His employer auto enrolled him in a retirement plan and now he is learning about saving and investing. Excellent!

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