The Illusion of Control

According to this Barron's article, 85 percent of investor sell or exchange decisions are wrong.

The Money Paradox

That means:

...the investor would do better by doing nothing or going the other way that 85% of the time. Simple random decision making (with no investment knowledge) would have yielded about 50% good decisions.

The article also makes the point that, in the 20 years ended in 2008, a 1.9 percent annual return was achieved by equity fund investors even though the average fund produced 8.4 percent annualized returns.

The reason? Lots of buy and sell transactions intended to preserve capital or juice returns. Moves that all likely seemed wise at the time but, in fact, were an illusory sense of control. Doing nothing would have produced much better results. More from the article:

This is a compelling demonstration of the illusion of control, the mistaken belief that better results come from more-direct, detailed control and using it to make lots of decisions and transactions.

The illusion of control explains one of the many reasons I'm in favor of an investing approach that minimizes trading activity and the associated frictional costs.

Keeping the explicit frictional costs (commissions, taxes etc.) themselves down is smart, but the above starts to get at what I think is a much more crucial, even if somewhat more subtle, reason to adopt an approach that involves as little trading as possible.

Naturally, every decision is another chance for a favorable outcome or to make a mistake.* The fact is, when a buy/sell decision is made, many don't think or realize the odds are stacked against them as much as the evidence shows.

Now, I'm guessing many think they're not one of the investors who gets it wrong 85 percent like the study shows. If so, just keep in mind the survey that revealed 90 percent of swedish drivers think they are above average.

"Demosthenes noted that: 'What a man wishes, he will believe.' And in self appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90% of automobile drivers considered themselves above average." - Charlie Munger speaking to the Foundation Financial Officers Group in 1998

So if, as the above suggests, investors tend to get their buy/sell decisions wrong 85 percent of the time what's the best way to improve performance?  It's far to easy to make the mistake of overemphasizing the potential positive outcome while not properly weighing the downside. The only solution that I know of that works comes down to the following: 1) reduce the number of buy/sell decisions one has to make then 2) use that freed up time and energy to focus intensely on the relatively fewer remaining decisions.

I'll take that a bit further.

There are only so many investments that most of us can really understand well.

Developing a comprehensive understanding of the long run economic characteristics of a business and the risks involved just is not an easy thing to do.

On those rare occasions an investor is able to develop a real comfort-level with a specific investment, then it comes down to knowing how much of a discount should be paid relative to value and building a meaningful position.

That whole process sounds simple enough but in the real world, at least for most mortals, it isn't easy to get consistently right.

So, considering the difficulty of getting it right and the work involved, why then sell something just because it happens to be gyrating around in the frequently manic then depressed stock market?

The only logical reason, it seems to me, would be that the economic characteristics of the investment changes materially** or price action takes valuation to extremes.

"...when we own portions outstanding businesses with outstanding managements, our favorite holding period is forever." - Warren Buffett in the 1988 Berkshire Hathaway Shareholder Letter

The Illusion of control makes many think they'll get their buy/sell decisions right but the evidence suggests otherwise. An investor obviously has to make buy and sell decisions at least occasionally but it's wise to develop an approach that minimizes the need to do so.

"We continue to concentrate our investments in a very few companies that we try to understand well. There are only a handful of businesses about which we have strong long-term convictions. Therefore, when we find such a business, we want to participate in a meaningful way." - Warren Buffett in the 1988 Berkshire Hathaway Shareholder Letter

I think that finding good businesses with the idea of owning them "forever" and concentrating on "companies that we try to understand well" can go a long way toward solving the illusion of control problem.

Well, lets just say it works just fine as long as the ability to judge value and how it will change over time tends to be sound.

Adam

Related posts:
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* The error of not giving equal consideration to both a favorable outcome and the downside risks is easy to make. It's, in part, confirmation bias at work. More than a few seem to underestimate how susceptible most investors are to this kind of mistake.
** That's why finding businesses that tend to have durable economic characteristics (high return on capital) is more important than extreme growth prospects. By owning shares of durable businesses with high return on capital, the economics of the business itself (not skillful trading) does the heavy lifting when it comes to generating long-term returns for owners.
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