What Is the Illusion of Control Bias?

The illusion of control bias is a type of cognitive bias that leads people to overestimate their ability to control events that are actually uncertain.

When it comes to finance and investing, the illusion of control bias can lead investors, analysts, or portfolio managers to believe that they have more control over the outcome of their analysis or investments than they actually do. This bias can affect anyone, regardless of age, gender, or socioeconomic status.

Key Takeaways

The illusion of control bias is a cognitive bias, rather than an emotional one, that occurs when individuals overestimate their ability to control or influence outcomes.
This bias can lead people to engage in behaviors such as overtrading, market timing, or holding concentrated portfolios, resulting in suboptimal investment returns.
To mitigate the illusion of control bias, investors should focus on evidence-based strategies, such as diversification, maintaining a long-term time horizon and avoiding micromanagement.
By recognizing the potential for the illusion of control bias, individuals can make more rational and effective investment decisions based on sound principles.

Understanding the Illusion of Control Bias

Typical examples of the illusion of control bias can occur during attempts at stock picking, market timing, and day trading.

Stock picking: The illusion of control bias can pop up when analysts and investors believe that they have the ability to pick stocks that can beat the market. After spending time researching stocks and analyzing financial statements and charts, they allow themselves to believe that they have some control over the outcome of their analysis and investments.
Market timing: Investors and traders attempt to time the market because they think that they know when the financial markets will rise or fall. They think that they have insight into the direction of the markets.
Day trading: With the illusion of control bias, traders think that they can have control over their performance by trading frequently. They attain a sense of satisfaction from trade execution and quick profit generation.

Why the Illusion of Control Bias Happens

There are several contributors to the illusion of control bias. It can occur due to someone’s general cognitive biases, overconfidence, lack of information, or need for control.

General cognitive biases: Individuals such as analysts and investors can be influenced by cognitive biases such as confirmation bias, which leads them to find information that confirms their pre-existing beliefs, or attribution bias, where people are more likely to credit themselves for positive outcomes and blame negative outcomes on other factors.
Overconfidence: Overconfident people are more likely to believe that they can control the outcome of their analysis and investments. This can lead them to engage in risky or speculative behavior and may result in poor investment decisions.
Lack of information: Engaging in the illusion of control bias can be a result of having limited information about the financial markets or individual companies and securities. Investors tend to engage in activities such as overtrading or stock picking to compensate for their lack of knowledge.
Need for control: Another factor that contributes to the illusion of control bias can be having a need for control. This would cause the individual to take part in behaviors that gives them the sense of control they crave over their analyses and investments, even if it’s not based on sound principles.

Who May Be Susceptible to the Illusion of Control

Retail investors, professional investors, corporate executives, and financial advisors are all susceptible to the illusion of control bias.

Individual investors are often vulnerable to the illusion of control bias, as they may feel that they have more control over their investments than they actually do. Nonetheless, this cognitive bias is not limited to the retail level. Even professional investors working for institutions like hedge funds and mutual funds and trading millions of shares daily are susceptible tot his bias.

These professionals may feel pressure to produce high returns for their clients, which can lead them to engage in riskier or more speculative behavior in an attempt to control their investment outcomes. Also, corporate executives may feel prodded to make bold or aggressive investment decisions, even if the outcomes are largely out of their control.

Even financial or investment advisors, who are responsible for managing their clients’ investments, can be susceptible to the illusion of control bias. They may feel forced to generate high returns for their clients and then make decisions that are not based on sound investment principles.

Impact of the Illusion of Control Bias on Investment Decisions

The Illusion of control bias can lead to overtrading, portfolio concentration, and risky decision making.

Overtrading: Individuals with the illusion of control bias may engage in excessive trading, buying and selling of securities frequently in an attempt to control their outcomes. Overtrading can bring about above-average commissions and fees, taxes, and potentially reduced returns.
Portfolio Concentration: This impact can occur as investors think that they can identify individual securities that will perform well and even beat the benchmark. However, concentrated portfolios can increase exposure to idiosyncratic risk and can result in larger losses if those concentrated securities perform poorly.
Risky decision-making: Individuals with the illusion of control bias may take on more risk than they are comfortable with or that is not in line with the relevant statutory documents such as an investment policy statement or prospectus. They believe that they can outperform the market and this can lead to large losses.

Ways To Mitigate the Illusion of Control Bias in Investing

There are several ways to mitigate the illusion of control bias. For one, individuals can apply diversification to their portfolios. With a portfolio of diluted and uncorrelated assets spread across multiple asset classes and sectors, investors can reduce their exposure to idiosyncratic risk and market volatility.

People also should focus on the long term rather than short-term trading. By focusing on investment goals and maintaining a long-term perspective, investors can avoid the temptation to engage in market timing or overtrading, which can be costly in the long run.

Another way to limit the illusion of control bias by developing a clear strategy and sticking to it. Through strategy development and execution, particularly a strategy based on sound investment principles, people can avoid relying on activities that give them a false sense of control over their investment outcomes.

Additionally, investors should seek out diverse perspectives and advice from experts. Professionals in finance and investment have the potential to assess the situation and make more informed decisions. This approach reduces the reliance on one’s own beliefs and assumptions, so it can help to reduce the illusion of control bias.

Finally individuals should be aware that the illusion of control bias is just one of many cognitive and emotional biases. Being aware of biases such as confirmation bias, can help investors take first steps to be aware when they are being influenced by biases so as to avoid making decisions that are not based on sound investment principles.

What is the Difference Between the Illusion of Control and the Paradox of Control?

The illusion of control bias is a cognitive bias that refers to the tendency of individuals to believe that they have more control over a situation or outcome than they actually do. On the other hand, the paradox of control refers to the situation in which, in an attempt to exert control over a situation, one can actually lose some control. While both the illusion of control bias and the paradox of control relate to the concept of control, they are distinct concepts that refer to different phenomena.

How Is Micromanagement Involved in Illusion of Control Bias?

The illusion of control bias can lead analysts and investors to engage in micromanagement behavior. This is characterized by the desire to exert excessive control over the work of subordinates or employees. Micromanagers often believe they can control the work of their subordinates by closely monitoring their activities and making detailed decisions about how the work should be carried out. This may be rooted in insecurity or fear of failure. Nonetheless, this approach can be counterproductive as it can lead to decreased employee morale, productivity, and innovation—or less-than-optimal investing results.

What is the Money Illusion?

The money illusion is a cognitive bias that occurs when individuals focus on nominal dollar amounts rather than real purchasing power. This occurs when people fail to adjust their thinking for inflation and instead focus on the exact amount of money they have or the nominal return on their investments.

The Bottom Line

The illusion of control bias is a cognitive bias that occurs when individuals overestimate their ability to control or influence outcomes in situations in which chance or external factors play a significant role. In the context of investing and finance, this bias can lead investors to behave in ways that give them a false sense of control over their investment outcomes, actions such as overtrading, market timing, or holding concentrated portfolios.

The illusion of control bias can also lead to overconfidence and a lack of diversification in investment decisions, which can result in suboptimal returns. To mitigate this bias, investors should focus on evidence-based investing strategies, such as diversification and maintain a long-term perspective.