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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.2 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.3 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.

Infonnation. 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, an issue we'll discuss further in Section 5, "Investing and the Internet." 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.

RECIPE FOR DISASTER?

The attributes psychologists believe contribute to overconfidence are certainly common in our modern investment environment. Indeed, the ingredients for overconfidence by investors may be at their high­est levels ever! This overconfidence leads investors to have too much faith in their estimates of stock value and in predictions about the future movement of stock prices. The next chapter illustrates how overconfidence affects investor behavior.

OVERCONFIDENCE: A CASE STUDY1

The investor mania that took place over Iomega Corporation after its introduction of the Zip drive illus­trates how overconfidence can both affect investment behavior and cause market bubbles. Iomega introduced the Zip drive in the spring of 1995. Avid computer users and computer magazines raved about the product. At the same time, Motley Fool - a financial Internet service that was becoming a popular site for online investors - started a bul­letin board where investors could exchange ideas, informa­tion, and comments about Iomega. The fun had begun.

The early online investors were very computer savvy and loved the Zip drive. Consequently, they loved Iomega. As the conversation about Iomega heated up with the bul­letin board postings, so did the Iomega stock price. The price climbed from the split-adjusted price of less than 50<P a share at the beginning of 1995 to nearly $4 a share by the end of 1995. By this time, the illusion of control had set in.

Consider how the five key attributes that foster the illu­sion of control (from Chapter 2) were present and may have influenced the Iomega's true believers.

■    Choice. These investors chose to follow Iomega postings.

■    Outcome sequence. Most of these true believers experienced a doubling of the stock price during the last half of 1995.

■    Task familiarity. The more time the true believers spent exchanging opinions on the bulletin board, the more familiar they became with the company.

■    Active involvement. By reading messages and responding to board postings, Iomega supporters felt they were actively involved in the dissemination of information. By the end of the year 2000, there were over 59,000 messages posted!

■    Information. With so many messages, much "information" was being exchanged. I use the quotes to reflect the fact that the Iomega supporters (the true believers) had a very biased view of what was an important contribution to knowledge.

Information consistent with the true believers' prior beliefs about the greatness of the company was accepted without question. For example, by extrapolating the number of complaint postings about the Zip drive on an America Online site, someone named Charles Park believed that Iomega was selling Zip drives at a rate of 750,000 per year instead of the 500,000 consensus estimate. After his post­ing, his 50% increase in sales estimate became the new consensus estimate!

While positive news was accepted on the board without valida­tion (even from anonymous posters), negative postings were treated with disdain. People who posted opinions that the stock was overval­ued were insulted. Even indisputable negative news such as the com­pany reporting the loss of a big contract or competitors gaining market share was discussed so much that the news was twisted into good news. The Iomega true believers heard only the information they thought was consistent with their prior beliefs.

As the true believers expanded the message postings in 1995 and 1996, the stock price continued to climb. These investors were expe­riencing the attributes of the illusion of control. Did they become overconfident?

The year before these events unfolded, the average monthly vol­ume for Iomega stock was about 20 million shares. During the Iomega mania in 1995 and 1996, volume skyrocketed to an average 200 million shares per month. Some months saw over 500 million shares traded. Two years after the mania, the monthly volume was back down to 35 million. As you can see (and as we will discuss in the next section), overconfident investors trade!

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