Controlling your emotions and understanding your emotions are two different things. Controlling it might be a lengthy process, but understanding it and making your decisions effectively by getting adequate information is quite necessary to have a peaceful life.
However, we can help you with making informed financial decisions by introducing a concept of ‘illusion of control’ for managing risks efficiently. Let’s begin with the basics.
What is an illusion of control?
The ‘illusion of control’ is a cognitive bias that can affect investors and traders. It refers to the tendency of people to overestimate their ability to control or predict outcomes in situations that are largely determined by chance or outside factors. In the context of investing, the illusion of control can lead individuals to believe that they have more influence over the performance of their investments than they actually do.
For example, an investor may believe that they can accurately time the market or pick individual stocks that will outperform the broader market. This can lead them to take excessive risks or make trades based on a false sense of confidence.
In reality, many factors that affect the performance of investments are beyond an individual's control, such as macroeconomic trends, company news, or unexpected events.
Here are five consequences if you don’t focus on reducing the emotion of illusion of control while making an investment decisions:
When investors believe they have more control over their investments than they actually do, they may become overconfident in their abilities to predict the market or choose the right investments. This overconfidence can lead to poor investment decisions, such as taking on too much risk or failing to diversify their portfolio.
False sense of security
The illusion of control can also create a false sense of security, leading investors to believe that they are better protected against losses than they actually are. This can cause them to ignore warning signs and fail to take steps to protect their investments.
Blaming external factors
When investments don't go as planned, investors may be more likely to blame external factors, such as the economy or the actions of others, rather than accepting that their own decisions may have played a role. This can prevent them from learning from their mistakes and making better investment decisions in the future.
Investors who believe they have more control than they actually do may be more likely to engage in frequent trading in an attempt to control the outcomes of their investments. This can lead to higher transaction costs and lower returns, as well as increased taxes due to short-term capital gain.
Finally, the illusion of control can cause investors to overlook valuable opportunities that they believe are outside of their control. For example, they may fail to invest in promising companies or industries because they believe they cannot control the outcomes of those investments, even if the potential rewards are significant.
The illusion of control can also lead investors to engage in behavior that is detrimental to their financial goals, such as holding onto losing investments for too long or selling winning investments too soon. It's important for investors to be aware of this bias and to focus on developing a disciplined investment strategy based on sound principles and a long-term perspective.
Anushka Trivedi is a freelance financial content writer. She can be reached at anushkatrivedi.com