How The Illusion of Control Bias Impacts Investing

The illusion of control bias is the tendency for people to think that they have more control than apparent over events. It’s like wearing a rabbit’s foot to an exam or believing you’re safer driving than being a passenger. Neither can influence the outcome of events – good or bad – but the belief can cause real-world harm.

In reality, chance plays a bigger role than we give it credit for, and in the case of investing, this can hurt your finances. Whether you’re investing in the wrong things or investing too much, the illusion of control could hinder your progress towards financial freedom.

Why your brain cheats

Your mind is a powerful machine, but like everything else, it has limits. In a single day, you process 34 GB of new information. That’s the equivalent of 6,800 King James Bibles.

Every day, you’re flooded with new data – around 2.5 quintillion bytes’ worth  – so it’s hardly surprising your brain takes shortcuts, called cognitive biases. Without doing so, your brain would overload and shut down, leaving you unable to do even the simplest of tasks. 

These shortcuts are therefore beneficial for the most part, or at least harmless. The illusion of control bias, for example, encourages us to take responsibility for our lives and decisions. Such control over our destiny is an important part of our well-being, imposing order over a chaotic and unpredictable world that would otherwise terrify us.

But cognitive biases can disrupt rational thought. Often without you realizing it. This can spell disaster when you need to make important decisions, such as investing in a sound financial future.

Who’s really in control?

Ellen Langer explored the illusion of control in her 1975 paper, published in the Journal of Personality and Social Psychology. Langer argues that we are prone to overestimating our part in successes and underestimating it in our failures, ignoring the role of chance.

How readily you ignore the effect of chance, Langer argues, depends on certain conditions being met:

This illusion [of control] may be induced by introducing competition, choice, stimulus or response familiarity, or passive or active involvement into a chance situation. When these factors are present, people are more confident and are more likely to take risks.”

Think back to the last time you played the lottery. I’ll wager you picked your own numbers. The alternative would be a random selection, but despite both having an equal chance of success, we tend to believe our involvement (in this case, picking the numbers) gives us greater control over the results.

A lottery ticket is cheap, so the effect of this cognitive bias is relatively benign. But consider the same bias when choosing stocks or other financial instruments: the potential fallout is far more severe.

Worse, the illusion of control means you blame yourself when things don’t turn out as planned. You start retrospectively analyzing where you went wrong:

“Did I invest enough?”

“Did I invest at the right time?”

“Did I invest in the right things?”

This isn’t just stressful, but misjudging the cause of your errors can lead to further disappointment. You might correct a perceived weakness and still fail to achieve a better outcome.

Probabilistic vs. deterministic

Investing is a probabilistic endeavor. Decisions are based on mathematical, factual, and economic factors such as annual reports, market analysis, and the prevailing mood of investors.

However, the illusion of control can trick you into believing that investing is deterministic.  That your expertise in a particular field, for example, will determine the outcome of a probabilistic event. This almost always results in poor decisions:

..the task and environment faced by traders are conducive to the development of illusions of control and that individual propensity to illusion of control will be (inversely) related to trader performance

Trading on illusions: Unrealistic perceptions of control and trading performance

Mark Fenton‐O’Creevy, Nigel Nicholson, Emma Soane, and Paul Willman (2010)

What are the effects of investing under the illusion of control?

1. You can under-diversify

Concentrating your investment into businesses or sectors you believe you have control over in some way, means you can under-diversify. Perhaps you’re a former bank employee and favor its stock over competitors’. However, this increases risk and exposes you to losses that might’ve been mitigated by a more diverse portfolio.

2. You can trade too often

Believing that your skill or past successes give you greater control over the outcome of your decisions may cause you to adopt bad trading habits. You might already run a profitable portfolio of investments, so this could encourage you to trade more often than necessary. The results are increased trading costs and exposure to unhealthy risk.

3. You can overestimate the value of information

Believing that a wealth of data allows you to predict what will happen in the future, is an overestimation at best. You might have read the annual report, analyzed charts, reviewed historical patterns, and gone “all-in” without properly assessing the role of chance.

How to beat the illusion of control (and make better financial decisions)

To achieve true financial freedom, you should learn how to beat cognitive biases. Just being aware of the illusion of control puts you in pole position. For greater protection, I recommend the following:

  • Remind yourself of the illusion of control before making material decisions. Plan for how you’ll cope should a well-researched investment turn sour. Diversify to mitigate this risk.
  • Seek information that contradicts your opinion. Not only does this mitigate the illusion of control, but avoids falling victim to another cognitive bias called confirmation bias (only recognizing information that confirms your opinion while ignoring everything else).
  • Be sensitive to warning signs. When caught under the illusion of control, it’s easy to dismiss warning signs as inconsequential, but don’t be fooled.
  • Be wary of establishing causal links between your choices and the outcome of your investments. Yes, you might have made the right choice but luck probably played a part. So invest cautiously anyway.
  • Establish your appetite for risk before making investments. The sweet spot between risk and return is tough to measure and the illusion of control can make that assessment even harder. Whether you’re risk-averse, risk-tolerant, or risk-seeking, invest only what you can afford to lose!

Our cognitive biases help us navigate a complex, dynamic world, but when it comes to investing, the illusion of control bias can be detrimental to your future. Understanding your cognitive biases is the first step to taming them and leveraging such knowledge will give you an investment edge.

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