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The Illusion of Control

January 23, 2009

For years, academicians and researchers have claimed about efficient market hypothesis. Which means, in short that humans make efficient decisions on the basis of all the information at hand and the sole focus is to maximize profit and minimize losses. The idea being humans are essentially homo economicus in trading pits.

Successful Traders for ages knew this is a wash. And their only ‘edge’ in their arsenal was to realise that humans are homo sapiens full with emotions, greed, fears and despair rather than uninteresting almost robotic homo economicus. In effect, very subconsciously, what they are trying to do is not predict prices. But they are trying to predict the general tandem of human emotional flow. Crowd behavior is very primitive and marred by several biases. Or should I put it better humans are riddled with their own biases and illusions.

A few biases:

A few of them are :

  • Recency Bias : The bias to consider recent data more heavily than historical long term data
  • Representation Bias : The bias to consider,because something is represented a particular way, it necessarily means something important.
  • Lotto Bias or Illusion of Control: The bias to consider higher odds are in favor, since you can control a ‘variable’.
  • Bias of small number conclusions: The bias to draw conclusions from a very small number of cases.
  • Conservatism Bias [or Karl Popper Bias]: The bias to actively ignore conflicting ideas into decision making process, once a conviction is made
  • Disposition Bias : The bias to roll the gains fast, yet not cut out the losses. Or loss averting psychology of humans rather than, gain-seeking.

There are a lot more biases and you master one of those biases and defeat them, you have a slight edge over the crowd. You rake in more and more biases in your decision making system, you will progressively depreciate your edge.

The Human Interactions

Trading Pit: The Human Interactions

Trading System development is a hugely scientific pursuit and as associated with any scientific pursuit, the majority of the results are not supposed to be of any worthy significance. But, pressure from marketing and commercial deptts. often outstrip this, and they tend to market even the systems which are bound to fail in future. But canny and savvy marketers pick those trades from historical data which have given some profit and market them as the system’s success stories. And effectively trapping gullible newbies.


Because of bias of small numbers. Show a newbie enough number of success stories and you will find a loyal customer. Enough here is very small. Say five to six charts.

Similarly, giving a winning system with appropriate real life examples and performance statistics, but the same person can’t withstand six-seven losses in a row, and chucks the system. Why?

You have the answer in the first and last bias in the list. Recency Bias cropping from Disposition Bias. That is, the bias to consider recent losses more heavily than historical performance statistics[even if he himself had a streak of wins]. This bias is arising due to loss-aversion.

Humans are loss-averse creatures. They tend to consider a 100 buck loss more heavily than 150 buck win. Hence, the factor.

You see, how complicated it becomes, when the biases entangle with each other generate even more powerful biases.

Lotto Bias or Illusion of Control, I must admit, is what made me write this article at the first place. This is a powerful bias because you can’t put a distinct finger on it and say, “hey, here it is”. This bias creeps up eerily. Let me explain, what is it, I am talking about.

Lotto Bias simply refers to the phenomena when giving control of a particular variable to the participant, makes him consider his winning more likely. The name stemmed from the Lotto game, where you are allowed to pick your own set of numbers for the lottery.

Even educated, otherwise rational people too were attracted to it, with their theories of a divine order, astrology, stars and planetary movement and numerology to pick numbers which will pay them off. In spite of knowing the mathematical probabilities being too low.

How does this stem in trading?

Good question, but each time, you find yourself gaping at daily charts while your strategy calls for a longer time frame, each time you call your broker to find out about the latest price ticks, each time you bring in more indicators, oscillators(yes!,even indicators) to predict the markets, you give in to the lotto bias.

As I write this, I am finding myself, occasionally, glancing at the price charts, knowing fully well that my stop is in place and is with the broker. But well, this gives me an illusion of control, whereas markets don’t care what I am doing or thinking.

My last point, of talking about discounting higher number of indicators and oscillators also, is  illustration of another bias. The representation bias. The bias to think, that just because, something is represented a particular way, it must mean something important. Sitting right over here, I can make off a mathematical formula with inane quantities like twice of closing price, half of opening price and a quarter of the average price. And I can bet my a** off, I will find a taker of this formula who will use it to predict  the prices. See, representation bias?

The good news is, self awareness of these biases is a very basic and first step to counter them. Simply fight these biases and you will be well on your way to better-dom. But don’t believe that, your psychology will not revolt against these biases. It will, thus leading to psychological draw downs. Hence to make it really work, pick up a system, rip it apart, understand each block of it, rip ’em again, refer to historical backtests, refer to real life tests,and then finally when you are convinced put it together, have full blind faith on it and adhere to it to a ‘T’.

It has helped me. I am sure, it will help you too. Many a times you will be tempted to cut your losses before the stops are hit, don’t do it. It is a tinkering which you can’t afford to do. Many a times you will be tempted to book your gains before your price objectives. Don’t do it. The focus rather should be on following the system than making money.

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2 Comments leave one →
  1. January 25, 2009 6:28 am

    Great article.


  1. The Illusion of Control « Mr. Billy II

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