The Illusion Of Control

Experienced investors know that that markets are often difficult to read and can be very fickle, also they can be extremely unforgiving if our judgement is not spot on. We also know that humans have a very strong desire for certainty; the research by Abraham Maslow on The Hierarchy of Hygiene factors demonstrates how certainty plays an enormous part in our lives and is an important component of our well-being.

So the investor is faced with two incompatible forces, the inherent uncertainty and instability of the marketplace and a deeply held personal desire for certainty, comfort and predictability. This tension is absolutely central to how we address markets, their volatility and perceived risk. The most common “coping strategy” in such circumstances is to adopt a mode of thinking called The Illusion of Control. By this I mean we seek ways to convince ourselves we are on top of things, and that we can, through superior skill, knowledge and self-assessed ability stay on top of any sudden shocks or volatility. In fact we often fool ourselves into believing that we can start to influence events or at the very least we “knew that was going to happen”.

One tell-tale sign of trouble is that we tend to underestimate the role of chance in human affairs and to wrongly believe games of chance to be games of skill. Many readers will know of the Gambler’s Fallacy and the false hope of the winning streak or hot hand in a game of chance. Here we try to super impose our own internal certainties on to outside events – in this case (gambling) where the game is specifically designed for us to lose money! Surely we know you cannot predict the next in the series of heads or tails – but a long run of say heads can create an overwhelming belief the next time it “must” be tails!

Also we should note that both novices and those who believe themselves expert in a field are all prone to overestimate their own abilities – research shows novices’ ignorance often blinds them to their lack of expertise, and equally galling, the expert in a field is often very unwilling to change their views, even in the face of solid facts!

So what can we do to try and straighten out our investment decision making?

The key lies in two characteristics we need to develop – firstly to acknowledge that we have no special insight when looking at a financial market – we may of course analyse a forgotten corner and therefore have more information than our competitors, but that doesn’t mean that we have an unassailable advantage – maybe just a small edge. That edge can be important but only if we keep strong controls in place on allocation size, develop a sensible stop loss strategy and realistic expectations of profit targets.

Secondly we are all experts at only hearing what we want to hear – the market place is full of information, news, rumours and gossip and we can fall into the trap of cherry picking this to find the facts that suit our position. One way to overcome this maybe to just reduce the overall amount of information we try to read and process – this is really a case of where less is more.

Three Thoughts for Investors
1. Guard against over confidence – this usually shows itself in taking greater and greater risks. Investors should always use strict portfolio management rules. The temptation to think this is “The Big One” can be fatal – fortunes are not make (and kept) by single dead certain investments. Your aim should be to invest in consistent risk adjusted size and to aim to win on a ratio of 2 to 1. In time this would be an extremely successful strategy.

2. Don’t confuse accuracy of information with greater performance. A lot of behavioural research points out that investors get plenty of additional confidence and comfort from more and more information but there is little evidence that it improves the accuracy of their predictions.

3. Most bad investment decisions and behaviour can be really helped by keeping an accurate decision journal – this is a difficult discipline, but writing down one’s reasons for an investment and keeping accurate records of what went right and crucially what went wrong can be a powerful tool in focussing the mind, and reminding ourselves we are not Masters of the Universe!

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