Illusion of Control Bias
Any stock market around the world is huge in size. It is made up of many participants who regularly buy and sell assets. Since there are so many buyers and sellers, and the money is spread out amongst them, none of them has complete control over the events that take place in the market. The fact of the matter is that investment markets are based on probabilities. Anyone who claims that they can predict the outcome of stock markets with complete accuracy is most certainly suffering from a mental bias. This bias is called an illusion of control bias. In this article, we will understand what this bias is and how it affects the decision making of a normal investor.
What is Illusion of Control Bias?
Illusion of control bias is the tendency of investors to believe that they have a certain degree of control over the outcomes of investment markets! Not all investors believe that they have complete control. However, a lot of them do believe that they have some influence over the market. In most cases, this is not true because investment markets are huge markets where trillions of dollars change hands every week. Hence, if an individual investor or even a small to mid-size institution believes that they are in control of the market, they may be wrong.
It is true that some of the investors predictions might come true in the short run. However, it may be a mere co-incidence and may not prove anything in the long run. A lot of times, investors feel in control of thier portfolios because they use techniques such as limit orders, etc., to buy and sell shares. However, in many cases, it just leads to unnecessary buying and selling as prices fluctuate within a given range. The illusion of control bias is also closely linked to the feeling of overconfidence, which has been discussed in another article.
How Does Illusion of Control Harm Investors?
A false illusion of control can cause some serious harm to the investors portfolio. Some examples have been provided below:
Illusion of control causes investors to take positions in penny stocks. This is because they believe that since the company is small, they can use their capital to gain a significant stake in the company and then control the outcome. However, a lot of these penny stocks are inherently risky because of the nature of the business that they are in. This illusion of control only causes investors to lose more money!
Investors with an illusion of control often tend to believe that they are experts in certain sectors. Hence, they concentrate most of their portfolio in one single sector or industry. This is where the problem starts since the portfolio is undiversified. An undiversified portfolio is likely to see severe fluctuations in value if an adverse event takes place.
Illusion of control causes investors to not pay attention to an opportunity when it arises. They may miss good entry and exit points in a particular stock because they had a false illusion of control.
How to Avoid this Illusion?
Now, since we have determined that such an illusion is bad for the investors, it is now time to understand how we can recognize and remove this illusion from our thought process so that we can make effective decisions.
The first and foremost step is to realize that when it comes to investing, there is no certainty. The profit which is earned from investing is a reward for risk-bearing. Hence, if there is no risk, ideally, there would be no need for a reward either!
Investors need to understand that all investing involves the use of probability, and hence there are several outcomes possible, controlling all of which are impossible. In order to really drill this point, investors must try and make a list of the number of factors that could influence the price of a stock. They would find that there are factors at the government level, the competitor level, the macro-economy level, the market level, and so on. Since there are so many diverse factors involved in this complex system, controlling it is almost impossible.
Investors must avoid investing in stocks or other financial instruments, which give them a false illusion of control. This is particularly the case when investors start investing in penny stocks or other asset classes where there are wild fluctuations in the valuation.
Investors must actively try to look at the risks involved in their investments. They should realize that since they do not control the outcome of the investment, there are many possible outcomes. Do they have the wherewithal to survive each of these outcomes is the question that needs to be asked by the investor? It would be prudent for the investor to be absolutely clear upon their investment time frame as well as the possibility that some things can go wrong during that time frame.
The fact of the matter is that if any broker or any investor tells you that they are in complete control of their investments, they are most likely not telling the truth. It is impossible for retail investors and even smaller institutions to make any dent in the functioning of the stock markets.
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