Humans have a great capacity for exercising control over their environment and for detecting patterns in the confusing mass of information they face. This capacity can also mislead; not least in financial markets.
Have you ever looked at the clouds and seen faces or the shapes of animals. Did you as a child see monsters start to form in the sounds and patterns of a darkened room? Perhaps you have played with optical illusions such as the one on the right.
Human perception is a process of sense-making and pattern recognition. We recognize people, places and situations, without even noticing the process, as we go about our daily lives. We are hard-wired to seek out and recognise patterns. Without this capacity we could not function, but it can also mislead us. One of our most fundamental drives is to make sense of the world and control it.
Years ago I worked in a therapeutic community with adolescents who were the survivors of childhood abuse. Time and time again we saw that in their desperation to make sense of the abuse they had suffered, they would rather believe it was their fault and that they were bad people than accept that they were helpless and had no control over these terrible events.
This is just as much a factor in the less extreme situations of our everyday lives, and in our work lives; including financial decisions. Being helpless and out of control generates such negative emotions that we are highly motivated to re-establish control. If establishing control is hard or impossible, just like the survivors of abuse, we often succumb to comforting illusions.
The ‘illusion of control‘ was first studied by Ellen Langer who demonstrated this tendency to assume we are more in control than is realistically possible. Her initial work was in gambling studies. In one study participants were given lottery tickets, with the lottery numbers pre-chosen. They were then given the opportunity to pay for the right to choose their own numbers.
Many did this despite it having no effect on the odds of winning. Langer explained this in terms of the greater perceived control when you choose your own numbers. Similarly, most people when asked to rate the attractiveness of a bet based on guessing the outcome of a dice throw, give a higher rating when the dice still have to be thrown, compared with a bet in which the dice have already been thrown and are hidden under a cup. If the dice have still to be thrown, there is a greater sense of control over the outcome, although the odds remain the same in both cases.
Conditions leading to illusions of control for traders
Illusions of control can be an especial problem for traders. Trading is skilled work, but good traders often lose money and poor traders can get lucky. There is a lot of noise in the relationship between skill and performance. This can be a source of enormous performance anxiety for traders. The trader who gets lucky early on and develops an undeserved reputation (and bonus) for good judgement will feel under great pressure to maintain a level of performance that is beyond them. The good trader who is having a period of bad luck and diminished confidence can see earnings and reputation suffer. But traders build up financial commitments that reflect their earnings and faced with an inability to sustain performance (and status) can feel under tremendous pressure to take unreasonable risks or bend the rules.
This is exacerbated by the human capacity to fool ourselves. Not only are we loss averse, taking risks to avoid loss, but commonly we seek to avoid negative emotion. This can be useful in focusing us on behaviours likely to resolve the situation causing distress. However, we sometimes engage in less productive strategies to resolve the pain; hiding behind self-protective illusions. Individuals deprived of a sense of control make active efforts to restore it cognitively. Some cope with the discrepancy between desire for control and the world they face by denial and retreat into self-protective illusion .
Key elements of the trading environment are particularly conducive to the development of illusions of control as we describe below:
Markets are in practice very ‘noisy’: there is a lot of trading going on that is not based on information genuinely relevant to the value of an asset . On any individual trade it will be difficult to tell whether an outcome (positive or negative) is the result of trading on information or of essentially unpredictable market movements. Hence, it will often be difficult to determine whether an outcome was contingent on a trader’s information and skill. At the same time traders are highly motivated to establish causal relationships between information they hold and market movements.
Illusions of control are more common in circumstances of stress . Trading is a highly stressful activity in terms of workload, time pressure, visibility and uncertainty coupled with limited control opportunities, and professional traders suffer much higher levels of free-floating anxiety than the general population .
Illusions of control are more common in competitive environments [2, 3]. The process of trading is innately competitive. The markets in which traders deal, are founded on competition between market actors. Furthermore, for professional traders, dealing rooms are often highly competitive environments.
Implemental mind set
Illusions of control are both more common and more severe when conditions induce an implemental (focus on goals) mind-set than when they induce to adopt a deliberative (reflection on action-outcome contingencies) mind-set . The bonus system and associated targets are designed to keep traders goal-focussed. The short-term nature of information advantages also means that traders are unlikely to forgo the opportunity to trade in order to learn more about the value of information or a strategy, by observing the market.
Choice, involvement and familiarity
Choice, involvement and familiarity can act as cues suggesting that skill is relevant, leading to an illusion of control . Trading involves continually making choices but more importantly requires close focus on a particular type of instrument or market. Traders are often highly identified with the instruments or markets in their area of expertise.
Illusions of control and trading performance
In a study of 107 traders in four City of London investment banks, we used a computer based task to measure propensity to illusions of control . The findings were striking. Trader performance was inversely related to susceptibility to illusions of control including as measured by managerial ratings of risk management performance. Traders with high illusions of control were paid significantly less, contributed less on average to desk profits and were rated by managers as poorer at analysis and risk management.
Illusions of control are just one example of the human capacity for self-deception. As any con man knows, properly motivated by strong emotions such as fear, status anxiety or greed, people are endlessly creative in their capacity for self-deception. Intelligence is no defence since it simply implies greater cognitive resources to be marshalled in the cause of self-deception. Emotions guide what we pay attention to; and these effects don’t just apply to middle ranking traders. It seems at least plausible that senior managers in large financial institutions who failed to ask what extraordinary risks attached to extraordinary profits being made in sub-prime mortgages or who failed to notice the systematic rigging of the LIBOR rates were in the grip of self-deceiving illusions fostered by intense pressures for success and fear of failure.
Paradoxically, those who show the least emotion may often be at greatest risk. There is evidence that people who manage their emotions by suppressing them may, in the end show stronger effects of those emotions than those who consciously attend to them and use strategies such as ‘reframing’ to modify their emotions .
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