Illusion of control bias. The truth is that no one can control the market; a blind belief that you are The One renders your investment goals unreachable.

The illusion of control bias is a behavioural pattern where a person believes they can control or influence the results of a process, when they cannot. This bias leads investors to trade more frequently and hold more concentrated positions, resulting in poorer investment results. Discover whether you are prone to an illusion of control bias and the extent to which it affects your investment decisions with  PRAAMS BehaviouRisk.

Behavioural science. What is illusion of control bias?

This bias describes a behavioural pattern whereby a person believes that he can control or influence the results of a process, whereas he cannot. A typical example is throwing dice: many committed casino players are convinced that the way they throw dice influences the final sum. Psychologists from Harvard University found that the illusion of control bias becomes more acute when decision-making is undertaken in competitive environments or with active involvement. These are familiar feelings for an individual investor in the financial markets. 

Illusion of control is a cognitive bias, i.e., a mistake in decision-making. These biases can be effectively corrected with education.

What are the consequences and investment risks? 

Illusion of control bias pushes investors to trade more frequently – especially those engaged in active portfolio management or online trading. Studies show that excessive trading among individual investors leads to poorer investment results. This bias also encourages investors to hold more concentrated positions, especially in stocks of the companies over which they believe they have control or better-than-market understanding. Using specific techniques such as iceberg or limit orders gives the illusion of better control over the trading risk factors and exacerbates the effect of the bias. Finally, a widespread consequence is that investors who are successful in other areas of their lives – for example, their professional careers or businesses – falsely think that they will also be successful smart investors. However, investing is an entirely different sphere and requires a different type of knowledge, and the assumed transfer of ability may seriously harm the investment objectives. 

What can I do to make my portfolio more efficient?

It is wise to remember that sometimes confidence may stem from the illusion of control bias. Investing is always a game of probabilities, and no one knows anything much better than anyone else or with 100% certainty (if this is the case, it is most likely insider trading, an illegal trading practice). If you feel you have exceptional knowledge or control, it would be an excellent strategy to challenge the grounds for your confidence, for example, by considering the opposite viewpoint and performing an impartial risk analysis. Reassessment is essential if this assumed superior knowledge motivates you to invest more or trade specific financial instruments more frequently. This is also a beneficial exercise if you have above-average success in some other, notable area of life and tend to perform well in competitive or continually changing environments. Another piece of advice is to describe your investment decision in writing: when considering an asset allocation, write down five good reasons to buy and five good reasons to sell. It may be challenging initially, but it is an excellent exercise in disciplining oneself to obtain the whole picture. Finally, employing stop-loss or take-profit orders is a good idea, irrespective of whether you are inclined to illusion of control bias.