“Nothing is so difficult as not deceiving oneself.” 

― Ludwig Wittgenstein

Before we take a long and hard look at the world of investment risk, we are going to take a short side trip to look at a really interesting cognitive quirk of the human brain known as the “illusion of control” tendency.  We want to examine the “Illusion of Control” because as we talk about risk, the defining and quantification of risk, and our inability to define and quantify certain things, one really significant question needs to be asked.  The question we need to ask is this:  “Are we measuring this stuff in order to pretend that we have some kind of control over these uncontrollable things?”   If this does turn out to be true in some measure, by the time we have made our way through this series, we hope to be able to see how far that illusion stretches, and what portion of our risk measurement has meaning and value to an investor.    I will be drawing from a number of scholarly articles on this topic, but as this is a blog post, I am not going to cite them rigorously.  I will provide the sources to anybody who has an interest in them, if you email me and request them.  I will mention one source very specifically, because I think it represents a significant work on the subject, and that is Ellen J. Langer’s article from her Yale Doctoral dissertation in 1975.  The article is “The Illusion of Control” published in 1975 in the Journal of Personality and Social Psychology (volume 32, No 2, 311-328).    If you are interested in this topic, it is definitely worth a read.

 Figure 1--A famous optical illusion, do you see the young woman or old woman?  Our brains are pattern recognition machines, and lock into a meaning, even when multiple interpretations exist.  This leads us to infer many things, like the fact that certain behaviors inevitably lead to certain results, even if the results are actually incidental.

So, what is the illusion of control?

Perceived personal control is the ability to act and achieve desired outcomes, it becomes illusory when the connection between the action and the outcome is not causal.  There are clearly situations in the world which are “skill” situations, and those that are not.  If I proposed to pay the winner of a game of checkers 50 dollars, that case is clearly different from paying the winner of a coin toss.  The issue for us as a species is that sometimes our judgement about whether a situation is a skill situation or not can get a bit cloudy.   If you were subject to a particular manifestation of Obsessive Compulsive Disorder, you might be convinced that touching a framed picture of your sister thirty-three times each day upon waking will protect her from harm that day.  You might rationally know that this isn’t true, but there is also a logic to it that is seductive.  I have carried out this act every single day since that time she was in a car accident, you might think, and nothing bad has happened to her.  A study of gamblers throwing dice indicated that people tended to throw softly for low numbers and harder for high numbers.   So, the seductive illusion of control exists in the world, and in some cases is catered to by advertisers, which we will talk about in a bit.  First, lets look at few other implications of this particular brain wiring, which definitely affect us as investors, if we are not careful.  We will start by thinking about the evolutionary context and then follow one such thread from beginning to end.

After more than twenty years working with investors, I have had plenty of opportunity to observe how we think.  We are imperfect calculation machines, but we are really intuitive.  The human brain formed over tens of thousands of years of evolution to make decisions about things like the best ways to get food in places like the African savannah, and how to avoid getting eaten by wolves in the steppes of Eurasia, and does it in world of imperfect and missing information.  This brain is a wonder.  It can connect concepts in ways we only barely understand.  It does have some strange quirks, however.  One of those quirks is that it seeks connections to causality.  It has a pet fixation on attribution.  Attribution is a subject we are going to come back to, because our brains interest in it has some really interesting effects on investor behavior, but for today, we will just stick with the definition.  Attribution, in a social science context is how we explain events.  It is the cause leading to the effect.  If we press the walk button, and the walk light on the street lights up, the cause (in our mind) is pressing the button, and the effect is the light changing.  

As our forbears and their wonderful brains evolved to make sense out of their environments, this ability to connect cause and effect was of incalculable value in evolutionary terms.  It is a valuable system, but it is also slightly flawed.  One could say that it has evolved to err on the side of caution.  In an evolutionary sense it is better to see connections that may not exist than it is to miss connections that could be of vital importance to our survival.  So what does this have to do with investing?  It turns out that it has a lot to do with investing.  Stay tuned, and we will examine a few ways that this is true.  This is going to be a rather long post, because we are going to be coming back to if fairly often.  Bear with me.  For the moment, let’s go back to the crosswalk, and the walk light.

In New York City, the ubiquitous walk/don’t walk lights have been automatic for decades, but people still press the button, in the belief that this will speed up the light changing.  Eventually the light does change, and this reinforces the sense that the button caused it.   People are apparently more confident in their predictions on the outcomes of tossed dice when they toss the dice themselves.   People collect data to make decisions, even if the outcome is random, because it leads to a sense of control, which is subconsciously pleasing.  This can be witnessed in a casino, if you observe people watching the roulette table and keeping track of the past numbers that have come up, which are featured on a lighted board, and acting according to this perceived pattern. 

While attribution figures into this equation, along with lots of other factors, we are focusing on one factor specifically today.  We are focused on the illusions that investors tend to have, and many of those illusions come from a defining worldview referred to as the “Just World” hypothesis.  If you have some basic belief in a just world, that worldview, even if subconscious, has some implications when it comes to evaluating causes and effects.   The basic belief that “good things happen to good people” or that “what goes around comes around” can lead us to make inferences from events around us that are misleading.  An interesting study in 1965 asked subjects to evaluate two workers.  One of the workers had been randomly rewarded, the other had not.    Participants in the study broadly assumed that the rewarded worker was more capable than the other worker.  The companion study had subjects witness a peer receiving apparent electric shocks for minor failures in learning a complex task.    The control group evidently did not witness any punishments for the exact same performance, and it was found that those who saw the person punished rated their general competence lower than the other witnesses.  So outcomes are inferred to be just.    When life dishes out lemons, even if there was nothing we could do to prevent the situation from arising, or even if the circumstances that brought us into the condition were really ambiguous, our brains go back over the territory, sometimes compulsively to find the connections to create a causal link, so we can learn.  Sometimes it imagines these links very persuasively.

This brings us to the first way that illusions of control can manifest.  It also brings us to ways that we can be seduced into believing a situation to be one in which “skills” apply, as opposed to luck.  I love the example of coin tosses.  If I toss a coin, it will come up heads about half the time, statistically.   Imagine that I toss a coin once each day, and define success as getting heads.  If I pursue this game long enough, there will be runs of ten or twenty straight heads, simply due to random chance, one would expect a similar run of tails.  However, if I make the mistake of assuming that those results are purely from my skill, I would celebrate my abilities during my run of heads, and lament my failing thumb dexterity when the run was tails.   It is fairly widely accepted that direct action, or direct decision making control of a proxy actor, with said action or control being repeated with some kind of regularity is a major reinforcement mechanism for this illusion.  So, being dedicated to the daily coin toss, or making a phone call to ask about the coin toss, and direct it may amount to the same thing.  It is also likely that simply checking the result of said coin toss may have the same effect.

 If we go one step further and consider that the world financial system is vast, complex and influenced by more factors than any present forecasting model can contemplate, then we have a pool of investment managers all working diligently within that environment, all without any ability to predict the future.  They will all pick stocks.  Some will do well, others will do badly.  After three years, some of them will have picked stocks that have done consistently well, simply because statistically somebody was always going to.  Others will have picked stocks that did badly during this particular three year period, again, because statistically somebody was always going to.  Two companies that look very similar at the time of selection can have very different outcomes for reasons that are beyond any ability to predict.  A little iced tea company benefits from a celebrity commenting on how much they love the tea.   A property and casualty company has very little exposure in a city that suffers a terrible flood, and therefore can put up better results than a key competitor that year.  A media company has a hit show that nobody predicted, because some elusive set of tastemakers (a la the tipping point by Malcolm Gladwell) appreciate it.  These are the kinds of things that are clear in hindsight but very opaque at the time of investment.  Even with all of the work and skill involved in picking these companies, there is still luck present, where one manager picked the successful company, and another manager picked their less successful competitor.  In this scenario, I am saying that no amount of foresight would separate the two companies over our three year time period, and we will presume that the catalyst events were still a year away.    

During this time, an investor will often look at the three year returns of the “winning” manager and compare them to the three year returns of the “losing” manager and infer that the winning manager is more skilled, and that their rewards (positive results) were more deserved.  This is not necessarily true.  People can just have runs of luck, where the particular kinds of investment favor generate good results for a time.  The trouble is that this is not in any way predictive.  We have taken a situation that is random, and imagined that skill was the differentiator.    Again, I am not saying that these managers lacked skill.  I am only saying that we cannot assume that skill was the differentiator.  We cannot presume that luck was not involved.   You will also note that I highlighted the three year results as the most likely results that an investor would study.  There are a number of reasons for the popularity of this figure, which are anecdotally bandied about the industry.  I believe that much of the popularity stems from something known as the “recency illusion”, which we will talk about in another piece, which basically says that more recent events are considered more important than events further away in time.  It is a kind of reverse-chronology weighting system that our brains use to filter data inputs. 

Taking this to its next logical step, an investor (or investment advisor) evaluates the returns of the successful manager and compares them to our unsuccessful manager, and gathers up reams of information about the management during this three year period.  The returns are evaluated statistically, they are compared to peer groups, they are contrasted with alternate investment options,  the biography and history of the manager are studied, and then feeling an illusion of control, based upon all of the due diligence work done in this process, the investor makes an investment into this particular manager’s portfolio.  For a time this strategy seems profitable.  A year goes by and when checking back, the decision looks sound.  The investor usually congratulates themselves for their judgment.  However, at some time in the future the portfolio’s returns suddenly look less spectacular.  This happens for lots of reasons.  Maybe the particular manager really favors a kind of stock that is no longer going up, maybe the run of luck just ended, perhaps the manager makes some mistakes.   A common scenario is that the stock market, after rising for a number of years starts to go down, as the economy weakens.  The portfolio no longer looks as pleasing to the investor in these circumstances.  They in turn blame the stock market for their mounting losses, or in statistically fewer cases, berate themselves for being stupid, and taking risks they should not have taken with their hard-earned money. 

What I have articulated above is a fairly common scenario.  I have met hundreds of investors that followed this exact investment arc.  It was rampant during the “dot-com” bubble.  I saw it in the real estate bubble.  It is part of human nature.   What we see is two layers of the illusion of control playing out at one time.  The money manager because they are active presumes that they have control over their outcomes.  The inference on the part of the investor that skill is the only factor being rewarded leads them to make judgments about the manager, applying the “just world” mindset, and then following the logic of the gambler looking at the past spins of the roulette wheel gathers a bunch of data on that manager in order to make an “informed” decision, which they take credit for when it goes well.  Typically an outside agent is blamed for the eventual failure of the decision.  This is also part of the illusion of control.

What are the key factors that induce the illusion, and how is it recognized?

In the scenario above, the illusion is created by having choices.  We are wired to assume that any time we make a choice, our choice has consequences and our skill in making good choices will eventually pay off with good results.  Our brains have a hard time distinguishing whether the choices are being made in a “skill” or random setting.  This is why people choose lottery numbers rather than take random numbers most of the time (in fact this very issue was part of Langer’s 1975 study design).   Factors like choices, feedback stimulus as a result of choices and creating a sense of competition all have been shown to induce a sense of control, even when control does not really exist.  The illusion itself is thought to serve many purposes subconsciously, among them the sustaining of our self-image, and the maintenance of a broader worldview that makes sense to us, namely that the world is rational, and events and outcomes are linked, even if the links are not apparent.  Typically a dominant aspect of the illusion of control, and possibly a way to detect it, is that a person can take credit for successes, and pass the blame for failures on an outside factor.  In the scenario above the manager can take credit for great picks during the success phase, and blame a downturn or a rotation away from his sector for his disappointment phase.  The investor can take credit for thorough research during the success phase, and blame either the market or the manager during the disappointment phase.

There are certainly further elements of control that can be exerted in the above scenario.  As a matter of fact, there are many possible factors that might add elements of control.  The question is how much of the control is actual control, and how much is an illusion. Before we move on to the more in-depth look at distinguishing actual and illusory control, we need to discuss the various definitions of risk, as experienced by the investor, because the risks an investor takes and the return they achieve are related.  Once we have done that we can look at controllable and uncontrollable risks.

So, when we come back to this topic in part two of this piece, we will look at our control “calibration” to see how well we recognize the amount of control we have when making investment decisions, and try to figure out how we improve real control and minimize illusory control.  It is a tall order, but we will see what we find.   

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