Consider the Dartboard column frequently run by the Wall Street Journal. Periodically, the Wall Street Journal invites four or five investment analysts to pick a stock for purchase. Simultaneously, they pick four or five other stocks by throwing darts at the financial pages. They follow the analysts’ stocks and the dartboard stocks and report the returns produced by both sets. More likely than not, the dartboard portfolio beats the pros. Does the dart thrower have superior stock-picking ability? No, it’s just that dumb luck success is common.
People investing during the late 1990s probably experienced great returns—it is easy to earn high returns during a strong, extended bull market. Many new investors began investing during this period. The problem arises when the newer investors attribute their success to their ability. Thus the old Wall Street adage warning “Don’t confuse brains with a bull market!”
Psychologists have found that people become overconfident when they experience early success in a new activity. Also, having more information available and a higher degree of control leads to higher overconfidence. These factors are referred to as the illusion of knowledge and the illusion of control.
Illusion of Knowledge
People have the tendency to believe that the accuracy of their forecasts increases with more information. This is the illusion of knowledge— that more information increases your knowledge about something and improves your decisions. However, this is not always the case—increased levels of information do not necessarily lead to greater knowledge. There are three reasons for this. First, some information does not help us make predictions and can even mislead us.
Second, many people may not have the training, experience, or skills to interpret the information. And, finally, people tend to interpret new information as confirmation of their prior beliefs.
To illustrate the first point, I roll a fair six-sided die.What number do you think will come up and how sure are you that you are right? Clearly, you can pick any number between 1 and 6 and have a one-sixth chance of being right.What if I told you that the last three rolls of the die have each produced the number 4? If I roll the die again, what number do you think will come up, and what chance do you have of being right?
If the die is truly fair, then you could still pick any number between 1 and 6 and have a one-sixth chance of being correct, regardless of what previous rolls have produced. The added information will not increase your ability to forecast the roll of the die.
However, many people will believe that the number 4 has a greater (than one-sixth) chance to be rolled again. Others will believe that the number 4 has a lower chance to be rolled again. Both groups of people will think that their chance of being right is higher than reality. That is, the new information makes people more confident in their predictions, even though their chances for being correct do not change.
What return do you think the firm TechCron will earn next year? Don’t know? Last year TechCron earned 38% and it earned 45% the year before that. Now what return would you guess?
Of course, TechCron is just a made-up firm, so you have no other information. But how is this example any different from rolling the die? Frankly, it is not different. Yet, investors commonly use past returns as one of the primary factors to predict the future. Have you switched your money into one of last year’s best mutual funds? Investors have access to vast quantities of information. This information includes historical data like past prices, returns, and corporate operational performance, as well as current information like real-time news, prices, and volume. Individual investors have access to information on the Internet that is nearly as good as the information available to professional investors.
Illusion of Control
People become even more overconfident when they feel like they have control of the outcome—even when this is clearly not the case. For example—and this has been documented—if you ask people to bet on whether a coin toss will end in heads or tails, most will bet larger amounts if you ask for the bet before the coin has been tossed.
If the coin has already been tossed and the outcome concealed, people will offer lower amounts when asked for bets. People act as if their involvement will somehow affect the outcome of the toss. In this case, the idea of control over the outcome is clearly an illusion. The key attributes that foster the illusion of control are choice, outcome sequence, task familiarity, information, and active involvement. Investors may routinely experience these attributes.
Choice. The choice attribute refers to the mistaken feeling that an active choice induces control. Consider your local lottery game. People who choose their own lottery numbers feel they have a better chance of winning than people that have numbers randomly given to them. In the past, most investors used full-service brokers who advised them and helped them make investment choices. However, the rise of the no-advice discount broker shifted the decision making more to the investor.Modern investors must make their own choices as to what (and when) to buy and sell. The more active the investor is in the decision making, the higher the illusion of control.
Outcome Sequence. The way in which an outcome occurs affects the illusion of control. Positive outcomes that occur early give the person a greater illusion of control than early negative outcomes. Even something as simple and transparent as being right on the first two tosses of a coin can lead to an increased feeling of having the ability to predict the next toss. I illustrated the effect of the extended bull market on new investors earlier.
Task Familiarity. The more familiar people are with a task, the more they feel in control of the task. Investing has become a very familiar thing in our society. Consider these indicators: In 2000, CNBC (a financial news TV channel) surpassed CNN as the most watched cable news network. There are more mutual funds investing in stocks today than there are publicly traded companies to invest in. Terms like 401(k) and day trader are household terms.
Information. The greater the amount of information obtained, the greater the illusion of control.When learning new information, people place too much emphasis on how extreme or important it is. Too little emphasis is placed on validity or accuracy. Much of the information received is really noise and is not important—a lot of what we call information is inaccurate, hearsay, or simply outdated. In fact, some “information” used by investors these days is really an info bomb—a deception perpetrated by modern scam artists. As illustrated earlier, information does not necessarily lead to knowledge or understanding.
Active Involvement. The more people participate in a task, the greater their feeling of being in control. People feel like they have a greater chance of winning a coin toss if they flip the coin. Modern investors have high participation in the investment process. Investors using discount brokers must conduct their own investment decision- making process—they must obtain and evaluate information, make trading decisions, and then place the trades. This is surely an example of active involvement.
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