Michel Pireu Columnist
Picture: 123RF/KASTO
Picture: 123RF/KASTO

There is a concept in the psychological literature known as locus of control which, once defined, is easily understood. It is an individual’s belief system regarding the causes of his or her experiences and the factors to which that person attributes success or failure.

This concept is usually divided into two categories: internal and external. If a person has an internal locus of control, they tend to attribute success to their own efforts and abilities. The “internals” believe it is essentially up to them to succeed. Someone with an external locus of control will be more likely to attribute his or her success to luck or fate – factors beyond their control – rather than the strength and quality of their own efforts.

To put it in the context of investing, the internals would most likely agree with Steven Grey in The Myth of the Casually Competent Investor, when he says: “Nothing can substitute for the analytic rigor necessary to consistently outperform. Too many investors entertain a dangerously naïve disrespect for that basic research effort. Some in fact insist, apparently seriously, that the high failure rate of the professional investor only proves that such efforts are futile. After all, if the pros do all that work and with few exceptions still fail, what’s the point? But even a child understands that the way to outperform in most pursuits is to work harder and be more rigorously, not less.”

The “externals” are more likely to agree with Nassim Taleb’s assertion that we tend to miscompute the odds and wrongly ascribe skills when, in fact, it’s mostly about luck. “If you funded a million people endowed with no more than the ability to say ‘buy’ or ‘sell’, odds are that you will break even in the aggregate, minus transaction costs. But a few will hit the jackpot, simply because the base cohort is very large. It will be almost impossible not to have small Warren Buffets by luck alone.”

Buffett’s answer to that, of course, is to say: “What if 40 of those came from one place, say, Omaha? That’s no chance. Something’s going on there.”

“They both matter,” says James Clear, author of Atomic Habits: An Easy & Proven Way to Build Good Habits, “but hard work often plays a more important role as time goes on. Time erodes every advantage. At some point, good luck requires hard work if success is to be sustained.”

According to cognitive scientists Leonid Rozenblit and Frank Keil, we all think we know much more than we actually do. In their research, Rozenblit and Keil would mention something mundane  –  a zipper, a refrigerator, a toilet, things of that nature  –  and ask people to rate their knowledge of how these things work. Almost everyone rated their comprehension of the various items highly, but failed miserably to explain how they worked.

We think we know how our economy works. We think we know how international politics works. We think we know lots of things, but mostly we don’t. In addition, it appears that the more information we have, the more our mistaken confidence grows. This bias – to believe we understand how familiar phenomena work far better than we actually do – is called the illusion of explanatory depth.

Steven Sloman and Philip Fernbach, authors of The Knowledge Illusion, see its effect in just about everything. Reason being we’ve been relying on one another’s expertise ever since we figured out how to hunt together. “So well do we collaborate,” they say, “that we can’t tell where our own understanding ends and others’ begins.”

One area where it gets us into serious trouble is investing. It’s one thing to flush a toilet without fully knowing how it works, quite another to put your life savings into something you think you understand, but in fact don’t really know much about.

Is there a solution? Not really. The best Sloman and Fernbach can suggest is that we  – and especially the pundits on CNN –spend less time pontificating and instead come to realise how clueless we are and moderate our views. This, they say, may be the only form of thinking that will shatter the illusion of explanatory depth and change attitudes.

We believe what we hope to be true. We hold beliefs because they are what we desire to be true, despite reality or evidence to the contrary. It’s called wishful thinking.

In the markets it can be expensive. “Wishful thinking must be banished,” legendary speculator Jesse Livermore wrote as one of his trading rules in 1940.

Overly optimistic investors not only inflict financial harm on themselves but can negatively affect entire markets and even lead to market bubbles, say Nicholas Seybert and Robert Bloomfield, researchers from the University of Texas at Austin and Cornell University.

Their findings contradict what many people assume about markets: that wishful thinkers will be identified and disciplined by more sophisticated investors. Instead, investors fail to recognise the existence of wishful betting even though most of them do it. As a result, it is contagious.

“Our research sounds a note of caution to those who assume that market prices are always a sound basis for drawing conclusions about fundamentals,” warn Seybert and Bloomfield. “Traders in our study that observe price movements driven by what Keynes called ‘animal spirits,’ conclude that those price movements actually reflect news, and end up exacerbating market swings by their own responses. The cure lies in encouraging investors to engage in more fundamental analysis, rather than in outsourcing that analysis to the market.”

It’s difficult for people who buy shares at the bottom to hold on to them for very long. One of the main reasons is the “recency effect” – the human tendency to estimate probabilities not on the basis of long-term experience but rather on a handful of the latest outcomes. To anyone who bought at 5c, 30c is a high price, 200c would be wishful-thinking and 2,000c inconceivable.

As Victor Niederhoffer says: “I thought silver was cheap at 14 bucks. But my friends in the pit remembered it at three bucks and told me it seemed expensive to them. I’ve made the same mistake over and over with other stocks I’ve owned.”

This strong tendency to overweight recent events also has us thinking that what is going up will continue going up. And what’s going down will continue going down. It is one of the main reasons we fail to heed the lessons from reversion to the mean, which essentially says what goes up must come down. Something a lot of investors tend to forget.