There’s a story about Enrico Fermi, Nobel Prize winner who helped develop the nuclear bomb, talking with General Leslie Groves. The pair spoke about what it meant to be a ”great” general. Groves supposed that any general who won five battles in a row might safely be called great, and he thought no more than three in 100 would meet this standard.
Fermi responded that if the chance of winning a battle was 50%, then the odds of winning five in a row were merely equivalent to flipping heads on a coin five times – also around three in 100. In Fermi’s words, the definition from Groves represented “statistics, not greatness”.
Often only stories of dubious authenticity have endings that pithy, but there’s now a large body of psychological evidence supporting what Fermi was hinting at – the tendency for people to overestimate the control they have over the events in their lives. This "illusion of control", detailed in this 1975 paper of the same name, exists when people believe they have had a direct effect on an outcome – when in reality, luck, chance or other factors played a large role.
A lucky streak? Or a random sequence
Sports is a good example. This tendency can explain the "hot hand fallacy" in basketball, which relates to debunking beliefs that scoring several points in a row is a lucky streak – rather than a random sequence.
Another example might be a football manager who records five wins followed by five losses. Is he likely to attract more attention and be at more risk of losing his job than a manager who records win-loss-win-loss over 10 games?
Illusion of smart investing?
The illusion of control affects many areas of life – and personal finance is no exception. Think for a moment about someone who has prospered from investing. Individual circumstances will vary but perhaps they believe their current wealth was made by a series of fortunate choices whereas, in truth, luck and general economic conditions favoured them.
The 2007-2012 global financial crisis may provide evidence on a much larger scale: governments and individuals around the world massively overestimated the control they had over the financial system.
Breaking the illusion
The illusion of control can be managed. Gary Klein, a psychologist specialising in decision-making, recommends a neat trick for evaluating major decisions. He advocates turning the usual process of doing a post-mortem when something fails to doing a "premortem" before it has begun.
The idea is simple - before starting a risky venture (such as launching a business or investing in shares), imagine the decision was made months or years ago and resulted in a dramatic, gigantic failure. Now, work backwards from there and think of plausible ways that the failure might have occurred. This method forces people to act against confirmation bias, the tendency to only look for evidence that supports your original belief.
A true expert?
A good question is how to determine a true expert from someone who has essentially been lucky over a long period of time. Both may appear self-assured on the surface, so evaluating ability based on how confident they seem is a bad strategy. Klein addresses this in a paper he authored with Daniel Kahneman, the Nobel Prize winning psychologist.
They conclude that true experts only thrive in environments with frequent learning opportunities and regular, unambiguous feedback on decisions. In other words, areas like firefighting and medicine breed expertise because firefighters and doctors are frequently faced with decisions and feedback. This might carry a warning for investors who are not regularly making decisions and getting feedback.
Use your illusion too
In terms of managing your money, a key takeaway from this research is the importance of calibrating your confidence level. When making big decisions about money, ask yourself how you know what you know. Is your confidence rooted in genuine expertise or luck?
Have you conducted a rigorous pre-mortum to take into account the probability of large risks? These strategies may help reduce your exposure to risk. In addition, cultivating healthy money habits may help prepare you for a situation in which your feeling of control turns out to be an illusion and takes a negative twist.
Having an emergency fund of three-to-six months wages is important preparation. But if you have such a fund and don’t need to use it, don’t be fooled into thinking you perfectly controlled events. There’s a good chance you were just lucky.