Here is how not to fall victim to the illusion of control
It feels good to be in control. Yet, more often than not, appearances are deceiving: We succumb to the illusion of control more frequently than we have bargained for. We then tend to believe that we have the power to mentally influence how things play out. Like in everyday life: when we pray to the gods to get a good parking space and it appears. Or at the casino when we bet a lot of money on red because our gut "knows" that red will win. On occasion, we pass on the illusion of control to a substitute: Think, for instance, of Paul the octopus who was supposed to be able to predict the outcomes of games during the 2010 soccer world cup.
It's a misconception to believe you have control over future events when in fact they are governed by other mechanisms or simply by chance. Speculators fall into this trap, as do investment consultants — and their clients too. The “Super Bowl Indicator” shows how far this can go: The outcome of the Super Bowl "predicts" how stock markets will fare in that year. If a team from the American Football Conference wins, stock prices will take a nosedive. If a team from the National Football Conference wins, they will go up. The sportswriter Leonard Koppettl first noticed this apparent causal relationship in the 1970s — which in reality is completely unfounded and, in many years, has failed to prove true.
The 2007-2009 financial crisis would, arguably, not have developed to the extent it did, had gamblers and speculators not fallen victim to the illusion of control. More often than not, they were unsuccessful in their attempts to ride on the wave of soaring real-estate and stock-market prices as well as over-valued “bundled subprime real estate mortgages” as regards to divesting themselves of their over-valued investments at the most favorable moment before the bubble bursts. All the would-be pundits and gurus failed to realize something fundamental: You cannot control financial markets.
That said, the fact that people fall into this fatal trap is the lifeline of the world's financial centers. It is precisely because investors believe they are in control and that there are plenty of orders to buy and sell is what promotes the required liquidity in financial markets.
In investment contexts, just like in life in general, it is good to remember that you simply can't be in control all the time! Often, chance has a say in how things play out. Don't believe “fair proof” tips, and do not rely blindly on your gut feeling—or the Super Bowl! Question existing models! Specifically, ask yourself: “Do I overestimate the extent to which I can control future developments?” or “What external factors are there that I should be mindful of but do not currently pay enough attention to?” If you come to the conclusion that you are vulnerable as a result of not being able to fully control something, make a conscious effort to reduce the risk you are taking (for instance by cutting back on debt financing)! Because this is a parameter you do have control over.
Keep in mind that a (stock-market) crash can happen at any time and that you may (at least temporarily) lose a lot of money in consequence! It is, thus, a good idea to develop a “crash plan” just to be on the safe side. If a crash happens, there is no point in getting panicky and divesting yourself of investments like most of the other investors. A much better strategy is to have a “c(r)ash reserve” up your sleeve and to invest it immediately after the price plunge. While stock prices are still high, decide how much of your crash reserve you will invest at what price (loss) level, and make a list of potentially promising investments that you would buy cheaply with your reserve in the event of a crash. Having such a detailed crash plan helps you keep your head cool in the heat of a stock-market crash - even if everything around you is collapsing.
This article was published in the Austrian business magazine GEWINN. Read the original article here (in German).