Zweig, Jason. Your Money and Your Braine
.pdfpath to success. As Kahneman puts it, "The combination of optimism and overconfidence is one of the main forces that keep capitalism alive."
Positive thinking can be useful, but extreme optimism is dangerous. For investors, there are several ways in which overconfidence leads to underperformance:
•We can make a level-headed estimate of the typical person's odds of succeeding at something, but we usually have our heads in the clouds when we size up our own chances at success. That leads us to take risks we regret down the road.
•We put too much trust in whatever is familiar. This "home bias" leads us to invest too little money outside the industry we work in, the region we live in, and the rest of the world beyond our national borders. It also prompts people to invest too much money in the stock of the firm they work at.
•We overstate how much power we wield over our own circumstances. This "illusion of control" causes us to become complacent, to put too little effort into planning ahead, and to be overcome by surprise when our investments tank.
•We tell ourselves that we foresaw what was going to happen—even if, in the past, we had no idea what the future would hold. By misleading us into thinking we did see what was coming, this "hindsight bias" makes us believe we can see what is coming. Worse, it keeps us from learning from our mistakes.
•Above all, we have a terrible time admitting when we don't know something. As nature abhors a vacuum, the human mind despises the words "I don't know." The more we know, the more we think we know even more than we do. We're even overconfident about our ability to overcome our own overconfidence!
The single biggest step you can take to improve your investing results is to stare long and honestly into a mirror to see whether you really are the investor you think you are. Are you truly above average? Are your own decisions the main force that shapes your returns? Is "buying what you know" the best investment approach? Did you really predict where the market was going? Do you know as much as you think you do?
The bad news is that, for most of us, the answer to most of these questions is No. The good news is that neuroeconomics can help you bring your confidence into synch with reality, making you a better investor than you may ever have imagined.
I'm the Greatest
Every month in the late 1990s, the Gallup poll contacted nearly 1,000 investors across the U.S. to ask how much they thought the stock market, and their own portfolios, would go up over the coming twelve months. In June 1998, investors thought the market would rise 13.4%—but their own accounts would go up 15.2%. By the peak of the bull market in February 2000, they expected the market as a whole to jump by 15.2%—but they thought the stocks they had picked would soar 16.7%. Even in the dark days of September 2001, when people expected the market to rise just 6.3%, they still expected their own stock picks to earn 7.9%. No matter how well the market might do, investors expected that their personal portfolios would earn about 1.5 percentage points better.
Of course, the stock market is not the only contest in which every person seems to think that he is a winner in a world of losers. Unrealistic optimism is everywhere:
• A nationwide survey of 750 investors found that 74% expected that their mutual funds would "consistently beat the S&P 500 every year"—even though most funds fail to outperform the Standard & Poor's 500-stock index in the long run, and many funds fail to beat it in any year.
•Only 37% of corporate managers believe that mergers create value for the buyers, and a paltry 21% think that mergers meet the strategic goals set by acquirers. However, when it comes to their own mergers and acquisitions, 58% of experienced managers say they have created value, and 51% believe they have met their strategic targets.
•College students were asked how likely various events were to occur in their own lives—and the lives of other undergraduates. The typical student said she was 50% more likely than her peers to be happy in her first job. She also thought she was 21% more apt to earn a good salary, had a 13% better chance of seeing her home double in value within five years, and stood 6% better odds of having a gifted child. What's more, she thought she was 58% less likely to become an alcoholic, 49% less likely to get divorced, 38% less likely to suffer a heart attack, and even 10% less likely to buy a car "that turns out to be a lemon."
•Finally, in what may be the ultimate form of unrealistic optimism, 64% of Americans believe they will go to heaven after they die; only one-half of one percent expect to go to hell.
In short, to evaluate ourselves is to lie to ourselves, especially when the evaluation requires us to compare ourselves to the average person. Inside each of us, there lurks a con artist who is forever cajoling us into an inflated sense of our own powers. The less skilled or experienced you are at something, the harder your inner con man works at convincing you that you are brilliant at it.
And that's good, up to a point. By fibbing to ourselves, we can give a needed boost to our self-esteem. After all, none of us is perfect, and daily life brings us into constant collision with our own incompetence and inadequacies. If we did not ignore most of that negative feedback—and counteract it by creating what psychologists call "positive illusions"—our self-esteem would go through the floor. How else could we ever get up the nerve to ask somebody out on a date, go on a job interview, or compete in a sport?
There is only one major group whose members do not consistently believe they are above average: people who are clinically depressed. These chronically sad people rate their own abilities very accurately —which, of course, may be one of the main reasons they stay so sad. Their depression has robbed them of the ability to fool themselves. As psychologists Shelley Taylor and Jonathon Brown put it: "The mentally healthy person appears to have the enviable capacity to distort reality in a direction that enhances self-esteem…and promotes an optimistic view of the future."
Fibbing to yourself is one thing, but telling outrageous whoppers is another thing altogether. Imagining that you're a good basketball player if you're merely competent probably won't get you into much trouble. But if you think you're LeBron James even though you couldn't score a basket from a ladder propped up against the backboard, then a game of hoops against tough competition is sure to leave you with either a crushed ego or a snapped Achilles tendon.
Investing works the same way. A pinch of confidence encourages you to take sensible risks and keeps you from storing all your money in the concrete bunker of cash. But if you think you're Warren Buffett or Peter Lynch, your inner con man is not telling little fibs; he's a big fat liar. You will never make the most of your investment potential if you think you have far more potential than you actually do. The only way to achieve everything you're capable of is to accept what you are not capable of.
That's surprisingly hard for most investors to do. Two studies have recently tracked what happens when the typical investor listens to his inner con man. In both cases, like fishermen spreading their arms and proclaiming that their catch was "this big," investors wildly overstated how well they had done.
In a survey conducted by Money magazine in late 1999, more than 500 investors reported whether their stocks or stock funds had beaten the market (as measured by the Dow Jones Industrial Average) over the previous twelve months. All told, 131 investors, or 28%, said their portfolio had beaten the Dow. They were then asked to estimate their rate of return. Roughly a tenth reported that their portfolio had gone up by 12% or less, around a third claimed to have earned between 13% and 20%, another third or so said
they had gained between 21% and 28%, and a quarter thought they had made at least 29%. Finally, 4% of the investors admitted they had no idea how much their portfolios had gone up—but they were sure they had beaten the market anyway! And yet, over those twelve months, the Dow was up 46.1%—vastly outperforming at least three-quarters of the investors who claimed they had beaten it.
In a second study, 80 investors received clear updates on how their mutual funds were faring against the S&P 500. Then, at the end of the experiment, the investors were asked how well they had done. Nearly a third claimed that their funds had beaten the market by at least 5%, and 1 of every 6 said they had outperformed by more than 10%. But when the research team checked the portfolios of the people who claimed to have beaten the market, it turned out that 88% had exaggerated their returns. More than a third of those who thought they had beaten the market actually lagged it by at least 5%, and a fourth of all the self-described market beaters finished at least 15% behind the S&P 500.
"This shows a shocking lack of learning," says psychologist Max Bazerman of Harvard Business School. "You have the right to try to beat the market, but you need to learn the odds—which suggest that you're taking a sucker's bet. And it's easy to have illusions about the future if you don't even have a grip on your own recent past."
Together, these studies suggest that most people are kidding themselves when they claim to beat the market. "Everybody wants to believe that they're special and better than average," says psychologist Don Moore of Carnegie Mellon University. "They think they can beat the market with their own special something. And it's remarkable how this illusion persists even in the face of evidence to the contrary."
It's also perfectly understandable. Most people would much rather listen to the blarney of their inner con man than measure their financial performance accurately. After all, their inner con man never has anything bad to say.
That brings us to a much larger lesson. When you watch financial TV, visit market websites, or read the financial press, you will be told that "down here in the trenches," investing is a contest, a fight, a duel, a battle, a war, a struggle for survival in a hostile wilderness. But investing is not you versus "Them." It's you versus you. As Jack Nicholson hollered at Tom Cruise in the movie A Few Good Men, "You can't handle the truth!" In fact, the single greatest challenge you face as an investor is handling the truth about yourself.
There's No Place Like Home
In March 2002, three months after Enron Corp. went bankrupt, I gave a speech to a group of individual investors in Boston. I reminded the group that when Enron went bust, its employees didn't just lose their jobs; their retirement funds were also wiped out. Enron's employees had put 60% of their retirement savings into the company's stock. When the shares crashed, Enron's 20,000 workers lost at least $2 billion. "You already work at your company," I told the audience. "The last thing you should do is take on a double layer of risk by putting your retirement money there, too." After all, I warned, "The company where any of us work might turn out to be the next Enron. And the only way to protect against that is to diversify—own the whole stock market, and make sure you don't put more than 10% of your retirement money into your own company's stock."
I was unprepared for what happened next. A man jumped to his feet and jabbed his index finger toward me. "I can't believe what you just said," he called out. "I completely agree that any company could be the next Enron. But that's why your advice makes no sense. Why should I move my money from the one company I know everything about to hundreds of stocks I don't know anything about? Diversifying doesn't protect me from the next Enron, it exposes me to every next Enron—and the stock market is full of them! I want my money where I know it's safe—in the company I work for and the company I understand better than any other one around. That's how I control risk."
As gently but firmly as I could, I responded that most Enron employees were sure, until the eleventh hour,
that it was one of the world's greatest companies and that nothing could go wrong. Enron was ranked No. 7 on the Fortune 500 list of America's biggest companies, its stock had vastly outperformed the market averages over the long run, and nearly every Enron employee believed the firm's official slogan, "The World's Leading Company." They never dreamed that Enron could implode. At a meeting for hundreds of employees in December 1999, Enron's head of human relations had been asked, "Should we invest all of our 401(k) in Enron stock?" Her answer: "Absolutely!"
My questioner, like the employees at Enron, suffered from "home bias," the tendency to think that the most familiar investments are the best. Around the world, amateur and "expert" investors alike are chronic homebodies:
•After AT&T broke up into eight regional telephone companies in 1984, investors chose to keep three times more shares in their local phone company than in all the other "Baby Bells" combined.
•Mutual fund managers prefer to invest in firms that are based nearby. The typical fund owns stocks of companies that are based ninety-nine miles closer to the fund's headquarters than the average U.S. company is.
•Mutual fund investors in France have 55% of their money in French stocks, even though the Paris bourse accounts for only 4% of the world's total stock market value. New Zealanders keep 75% at home, even though Kiwi stocks are less than 1% of the world's total. Greeks, whose stock market also makes up less than 1% of the global total, keep 93% of their investments at home. (It could be worse: Fifteen years ago, Japanese investors had 98% of their portfolios in domestic companies, right before Japanese stocks sank into one of the worst bear markets the world had ever seen.)
•Investors in 401(k) plans allocate only about 5% of their stock portfolios to companies based outside the U.S.—even though other markets make up half the value of the world's stocks.
•A study run jointly in the U.S. and Germany found that German investors expected their stock market to outperform the U.S. by two to four percentage points per year. Meanwhile, U.S. investors expected the Dow to beat the German market by almost exactly the same margin.
•Only 16.4% of 401(k) investors said they believe that the stock of the company they work for is riskier than the stock market as a whole.
Why do we feel so safe at home? The frontier between the familiar and the alien, between ourselves and the rest of the world, is incredibly narrow and near. The saliva in your mouth, for example, is so much a part of you that you take it for granted. This beneficial fluid aids digestion, relieves thirst, and helps keep your mouth clean. But what if someone asked you to spit into a clean cup, count to five, and then drink your saliva back up? Suddenly—now that it was "out there," instead of inside your body—even a tiny sip of your own saliva would seem disgusting. A few moments and a few inches outside your mouth is all that it takes to turn an integral part of you into something alien and revolting. That's how little time and distance there is between the comfort zone of the familiar and the danger zone of the outside world.
It makes sense, of course. If our early ancestors had not learned to steer clear of the germs, predators, and other dangers lurking outside their own bodies and beyond their immediate home ground, they would not have survived. Too much curiosity could kill the cave dweller. Over the course of countless generations, a preference for the familiar and a wariness toward the unknown were ingrained into the human instinct for survival. Familiarity became synonymous with safety.
The Eerie Power of Mere Exposure
Almost forty years ago, a psychologist named Robert Zajonc (pronounced "zye-ontz") began a series of extraordinary experiments. Zajonc started by having Americans listen to words like afworbu, kadirga, and dilikli. Then he asked the listeners to guess whether each word meant something good or bad in Turkish.
The more often a word was repeated, the more likely a listener was to feel that it stood for something positive. (In fact, most of these words were nonsense syllables with no meaning in either Turkish or English.) Next Zajonc displayed Chinese ideographs to people who had no familiarity with the Asian alphabet—and found that whether they thought each ideograph represented something good or bad depended merely on how often they had been exposed to it.
Zajonc dubbed his discovery the "mere-exposure effect." He flashed twenty irregular, octagonal shapes onto a dimly lit screen in a blazingly fast exposure of only one millisecond apiece—about one threehundredth the duration of the blink of an eye. At that speed, no one can make out the shape, and most people are unsure whether they saw anything at all. Then he showed pairs of octagons—one new, and one from the set he had flashed before—for one full second and in better light. When Zajonc asked which shape they liked better, people overwhelmingly preferred the one they had already been exposed to, even though they had no idea that they had ever seen it before.
Zajonc kept flashing. He showed one group of people a set of Chinese ideographs, five times each, in random order. He exposed a second group to another set of Chinese characters, each shown only once. All the ideographs were flashed for just four to five milliseconds—again, such a short exposure that most people can register it only subliminally. Then Zajonc showed the original ideographs again, randomly jumbled up with similar but new ideographs and a set of totally unrelated shapes. He let people look at each image for a full second—long enough to be conscious of seeing it—then asked how much they liked each one. It turned out that if people had first gotten five subliminal exposures to an ideograph, they now liked it much better than if it had been flashed only once before.
Then the story got stranger. Compared to those who had seen each Chinese character a single time, the people who had undergone repeated exposures didn't just like the old ideographs better. They also liked the new ones—and even the unrelated shapes—more. And the participants who had been exposed to repeated subliminal flashes ended up in a measurably happier mood than those who had been exposed to each image only once.
Being in the presence of familiar things (even when we are unaware of them) simply makes us feel better. "The repetition of an experience is intrinsically pleasurable," says Zajonc. "It augments your mood, and that pleasure spills over anything which is in the vicinity." Aesop had it wrong when he said "familiarity breeds contempt." In truth, familiarity breeds contentment.
You might think that your likes and dislikes are conscious choices, that your preferences are based on inferences you make from studying the evidence. Instead, Zajonc's findings show, our preferences come out of our experiences—regardless of whether they ever were conscious. Whatever we experience most often, we are most likely to end up liking. (One of the few exceptions is abstract art: No matter how many subliminal exposures to it they get, people still don't like it any better.) That helps explain why investors tend to overpay for the stocks of companies with famous brand names. It also shows why Peter Lynch's advice to "buy what you know" rang so true to people—even though many investors have lost their shirts doing just that.
Mere exposure might remind some people of the Orwellian idea of "subliminal seduction" popularized by Wilson Bryan Key in his book of the same name, published in 1973. Key argued that advertisers, by exposing us to endless repetition of subliminal images, dictate our spending habits and our very lives. Key claimed (falsely) that the word sex was covertly imprinted on Ritz crackers and that images of naked women lurked within the ice cubes in liquor ads. Others have claimed that moviegoers will gorge on popcorn if the words "BUY MORE POPCORN" are flashed onto the screen for a split-second.
But Zajonc points out that sentences cannot be understood subliminally. And while repeated exposure to the word sex certainly could improve your mood, it's unlikely to make you lust after salty crackers. The popular concept of subliminal seduction is nonsense.
The mere-exposure effect, on the other hand, is real. Just as the gravitational fields of the moon invisibly drive the tides, you cannot sense mere exposure governing your behavior—but it does. "Evolutionary theory suggests that you should pay the strongest attention to something which is novel or unknown to you," says Zajonc. "And if you keep encountering that novel stimulus over and over again and it does not bite you, then you are safe in the presence of this object. That makes your attitude toward it more positive, although you are probably not aware of that fact."
What's going on inside your brain during the flash of familiarity? Neuroscientists have scanned people's brains during one of Zajonc's Chinese-ideograph experiments. The scans show that even though you are unaware that you have already seen a particular Chinese character, your brain's memory centers are automatically activated by mere exposure. In effect, the repetition of images appears to submerge them deep into your brain: You have no idea these sunken memories exist, but they are there, waiting for a longer repetition in the outside world to float them up from the ocean floor of your consciousness.
Another study found that people who say they like Coke better than Pepsi cannot reliably tell which one they prefer in a blind taste test—and that the brains of Coke fans and Pepsi fans light up in essentially the same way if they drink either brand without knowing which one it is. When people see a labeled Pepsi can before they sip, the memory centers in the hippocampus region and the emotional circuitry in the reflexive brain are only mildly activated. But when people get a glimpse of that flaming red logo on a Coke can, their memory centers and emotional circuitry kick into high gear. You might think you like Coke better for the taste, when in fact you like it better mainly because it's more familiar. Likewise, investors plunk money into brand-name stocks—precisely because the brand name makes them feel good.
The "Halle Berry" Neuron
There are tantalizing hints that familiarity may be built one brain cell at a time. The hippocampus (from the Latin for "seahorse") is a lumpy crescent of cells buried toward the middle of your brain about one inch inward from your ears. A key part of the reflexive brain, the hippocampus is a hotbed of emotional memories. It is also packed with neurons that fire individually when you move through, see, or even imagine a specific location. These neurons are called "place cells" for their uncanny ability to tell each feature of your environment apart from the next. They constitute your inner map of the outer world— complete with dazzling detail, accessible with no effort. Place cells enable you to reach out in the dark and find a light switch without any conscious thought. Many experiments in rats have shown that the firing of place cells helps keep the brain focused on attaining a goal.
Once anything in your environment becomes relevant and important, a place cell in your hippocampus will activate whenever you encounter it again. The level of precision is nothing short of miraculous: Your brain appears to dedicate a single cell uniquely to every tangible element in your surroundings. That environmental cue might be a particular face, a given name, a specific building, the exact color and typeface of a company logo. It's as if one single neuron is dedicated, like a microscopic sentry, to recognizing each of these objects—and little or nothing else. Astonishing experiments at UCLA and Tel Aviv University have shown that some people have a single neuron dedicated to recognizing the distinctive schooner-shaped profile of the Sydney Opera House. Others have a place cell that fires exclusively when an image of movie star Halle Berry appears. The same cell will respond to her photograph, a drawing of her, or even the letters of her name—but not to an image of, say, Pamela Anderson. The names and faces of other celebrities, like Jennifer Aniston, Julia Roberts, and Kobe Bryant, also trigger a separate and unique response—each centered on a single neuron in or near the hippocampus.
London taxi drivers have an unusually large posterior hippocampus; their constant need to recognize city landmarks and memorize travel routes apparently causes place cells to proliferate in this area of their brains. In other people's memory centers, one cell is almost completely dormant around images of Ariel Sharon and Saddam Hussein, but fires up to nine times per second in the presence of pictures of Mother Teresa.
If you have a "Halle Berry neuron" in your brain, it stands to reason that you may have a whole host of "the company where I work" neurons. Each separate feature of your company may trigger its own distinct signal of familiarity within your brain, causing your place cells to fire in a rapid fusillade as you move among the landmarks in your workplace. The notion that place cells may fire in multipart harmony when you are in your "home base" helps explain the eerie power of mere exposure.
Brain scans in Peter Kenning's neuroeconomics lab at the University of Mьnster in Germany show that when investors consider putting money in foreign markets, the amygdala—one of the brain's fear centers —kicks in. These findings suggest that keeping our money close to home generates an automatic feeling of comfort, while investing in unfamiliar stocks is inherently frightening. Those responses originate in the biological bedrock of the reflexive brain. (No wonder that man in Boston got so mad when I told him to diversify.)
Once you understand the mere-exposure effect, it's easy to see why 401(k) investors consistently put too much money into the stock of the company they work for. Every day, employees are bombarded by their company's name and logo and products and services: on ID passes, computer screens, pens and pencils, memo pads, coffee mugs, key chains, baseball caps; in the parking lot, the cafeteria, the reception desk, the mailroom, the bathroom.
Just as a person standing outside in a thunderstorm could not possibly count the number of raindrops that hit him, you could never consciously track all the different ways you are exposed to your company during a typical day. But they all can activate your place cells, saturating you with a sense of familiarity toward the firm you work at.
In a recent survey, 55% of employees at roughly 100 different companies insisted that "owning my employer's stock does not affect my attitudes and feelings." Yet 4 in 10 felt that their employer's stock had "about the same level of risk" as a diversified fund—even though the shares of these companies had, on average, lost nearly twice as much money as the overall market over the previous five years! The best way to explain this blindness is that the constant reinforcement of the mere-exposure effect turns company stock into a "feel-good" investment. As employees become saturated with exposures to images of their company, owning its stock generates a subconscious pleasure that crowds out the question of whether the stock is actually worth owning.
Now it's clear why so many workers overinvest in their own company's shares. Roughly 5 million U.S. investors have more than 60% of their retirement funds in their employer's stock. Nearly one-tenth of 401(k) investors who can invest in their company's own stock have at least 90% of their retirement savings riding on it. And, while Merrill Lynch's brokers are supposed to prevent clients from putting too much money into the shares of the companies they work for, 27% of the money in Merrill Lynch's 401(k) is invested in—you guessed it—shares of Merrill Lynch stock.
The mere-exposure effect underlies other kinds of investment mind games, too. Professional financial analysts following the Tel Aviv Stock Exchange rated "more familiar" stocks as much less risky than "less familiar" ones—even though the pros should know that the stocks you think you know a lot about can lose at least as much money as the ones you've never heard of. In the stock market, the shares that are most popular and familiar to investors change hands more often, and that, in turn, attracts still more attention to these stocks as they turn up in the day's list of "most active shares." Because of all that extra exposure, the stocks with the highest trading volume have higher returns in the short run—but, in the long term, they tend to underperform by two to five percentage points per year. In the stock market, which is a game of inches, that's a country mile.
Mere exposure helps explain why so many investors are comfortable "buying what they know," investing in the stocks of companies whose products or services they use. Robert Zajonc, the psychologist, lives in Palo Alto, often drives past Google's headquarters in nearby Mountain View, and is a shareholder in the company. "I think I probably bought the stock," he admits a little sheepishly, "because Google is based
right here and I use it a lot." In other words, the man who discovered the mere-exposure effect realized only after the fact that his own portfolio may have been shaped by it. It's easy to see why any investor would love Google stock after clicking on the website countless times every day; each additional exposure to Google's services makes its users more familiar with it and more inclined to like it. The warm glow people get from the website casts a kind of halo over the stock price.
Unfortunately, history shows that good companies do not always make good investments. Whether a stock is a bargain depends not only on how great the company's potential is, but also on how many other people already know about that great potential. If you've become familiar with the high quality and growing popularity of a company's products or services, then plenty of other folks probably already are, too. And once hordes of people like a company, it becomes what finance professor David Hirshleifer calls a "celebrity stock." At that point, just like Kathie Lee Gifford or Mr. T, it is almost sure to end up overpriced, overexposed, and overdue for a collapse in popularity. No matter how great a business may be, its stock can't be an enduring moneymaker once an investor stampede drives the price up too high. Thus, over the long run, familiarity breeds failure.
I'm in Charge Here
Juanita Edwards is a bright, well-educated corporate designer who goes on vacation late every summer. On her last day at work, she takes her 401(k) money out of stocks and bonds and moves it all into cash. Two weeks later, when she returns to the office, she moves the whole thing back. "That way I know I'm in charge while I'm on vacation," she says, "and I can relax instead of worrying that I might lose money." Juanita suffers from what's known as the illusion of control. Like a bowler who thinks he can roll a strike by waving toward the middle of the lane after he lets the ball go, Juanita thinks she can control the outcome with her actions. But, while she's away on vacation, the market could just as well go up as down—meaning that Juanita is at least as likely to miss a gain as she is to avoid a loss. She's not really in control; she has simply created the self-delusion that she is.
The illusion of control is that uncanny feeling that we can exert some authority over random chance with our physical actions. There's no better example than watching someone rolling the dice in a board game or at a gambling table in a casino. When people want to roll a high number, they shake the dice for a long time and throw them hard. When they want a low number, they give the dice a quick shake and toss them more softly.
Long ago, the psychologist B. F. Skinner wondered what would happen if his lab equipment automatically swung a food dispenser in front of a hungry pigeon at fixed intervals. Before the first "meal" arrived without warning, the pigeons did what we all do when we have empty stomachs and nothing to eat: They fidgeted. In the final moment before the food appeared, one bird happened to be turning to the left, another was tossing its head up and down, a third was hopping from its right to its left foot. After that first peck at the food, the pigeons began repeating whatever they had been doing when it arrived. Acting as if their physical action had caused the food to come, they kept it up even when Skinner cut off the food. One pigeon hopped from one foot to another in the same way more than 10,000 times before it finally learned that hopping had no effect on whether it got fed. After all, food really had been delivered right after that earlier flap or hop or head toss, so it's easy to see why the birds "believed" that their prior actions had caused the rewards to arrive. But there was no causation, only what Skinner called "accidental correlations."
Humans make the same mistake whenever we confuse correlation with causation: We buy a stock because some website recommends it, then it goes up, and therefore we conclude that the website is a good place to get profitable stock tips. But the stock didn't go up because the website recommended it. Unless we can see a complete, independently audited track record of all the site's stock picks, there's no way to know whether this single call was the result of luck or skill. We might think we have found a way to exert control over the stock market, but it may be sheer coincidence.
To see how sensitive most of us are to the illusion of control, consider the following two bets:
A.I will pick a name at random from the stock tables in the Wall Street Journal. You will guess whether this stock will go up or down tomorrow. If you're right, you win $10; if you're wrong, you lose $10.
B.I will pick a name at random from the stock tables in the Wall Street Journal. You will guess whether it went up or down yesterday. (You are not allowed to look up the price.) If you're right, you win $10; if you're wrong, you lose $10.
Which bet do you like better?
In experiments at Stanford University, two-thirds of the participants took the first one. Most of these people were well aware that each bet has identical, 50/50 odds of winning. But the first bet seems more comfortable, because it does not make you feel as if the result is out of your hands. An earlier study found that people would wager more money, and even be willing to accept worse odds, if they bet before, rather than after, a pair of dice was thrown.
Psychologist Ellen Langer illustrated the illusion of control in classic experiments she conducted thirty years ago. Testing her theories on workers at two companies, Langer gave them each the chance to buy a lottery ticket for $1. The first group of workers got to pick their own tickets; those in the second group had their tickets chosen for them. Before the winning ticket was drawn, people were asked if they would sell their ticket. Those who had gotten to pick their own demanded a selling price four times higher, on average, than those who had not chosen the tickets themselves. The simple magic of making their own choice made them feel that they could somehow beat the odds—even though everyone had been told that the winning ticket would be drawn randomly from a cardboard box.
Thanks to the "I'm in charge here" feeling, we believe our own decisions are inherently better than the choices other people make for us. In an experiment at a Spanish university, students who won money by tossing dice themselves were much more confident that they would keep on winning than were those who won when someone else threw the dice for them. A study of retirement-plan investors in the U.S. who could either choose their own mutual funds, or permit someone else to decide for them, found that both groups exaggerated their actual returns over the previous year. The people who hadn't picked the funds themselves overstated their gains by 2.4 percentage points—but those who had made their own choices inflated their actual returns by a whopping 8.6 percentage points! The illusion of control explains why one of the worst nightmares for a financial advisor can be a client who picks his own stocks alongside the portfolio the advisor puts together: Even if the client's stock picks and those of the advisor go up by the same amount, the client will instinctively feel that "my" return is higher than "yours."
Study after study has asked people how confident they are of winning both before and after they place a bet. The mere act of putting money down makes people more certain they will win—and it takes only a few seconds for that certainty to kick in. Wagering as little as 25 cents can make bettors up to three times more confident than people who have not yet risked their own money.
Commitment raises our confidence, even when the odds of winning don't budge. It's as if taking the plunge somehow warms up the water; choosing makes us like our choice. No wonder so many investors say about a stock they already own, "I might not buy more at this price, but I wouldn't sell it at this price, either."
The illusion of control is stronger when an activity:
•appears at least partly random,
•offers multiple choices,
•involves competition against other people,
•can be practiced over time,
•requires effort, and
•feels familiar.
More than almost any other activity except sports or gambling, investing meets all these tests. Many investors suffer so badly from the illusion of control that they end up resembling Colonel Klink, the hapless commander on the old TV sitcom Hogan's Heroes, who thought he had an iron grip on every detail but was often oblivious to the chaos that constantly swirled around him.
From small-timers with just a few thousand dollars in a 401(k) to some of the biggest money managers in the world, investors everywhere fall prey to the Colonel Klink effect:
•"I never, ever, ever write with a red pen," institutional equity trader James Park of Brean Murray & Co. told a reporter in 2003; "red signifies losses." He added, "I also keep my desk completely organized. I feel the more organized I am, the better my stocks trade."
•According to research by Duke University anthropologist Mack O'Barr, many managers of pension funds seem to "have a neatness fetish," as if tidying up their offices could magically keep billions of dollars from getting messy.
•"There's lots of superstition," an institutional trader in London remarked about his colleagues. "If they had a bad day they'll not wear the same suit or tie again, or not drive to work by a particular route. If I had a new suit on a bad trading day, I wouldn't wear it again, even if it was brand new."
•In 2001, Blaine Rollins, manager of the $31 billion Janus Fund, announced that "I'm never going to take a vacation again until I improve the performance at my fund"—as if the portfolio's 14.9% loss the year before had somehow been caused by his personal holiday.
•Online stock traders often check their portfolios ten or twenty times an hour—as if, by not letting their stocks out of their sight for more than a few minutes, they could somehow keep their prices from dropping.
•Many 401(k) investors load up on their own company's stock in the apparent belief that they can levitate it all by themselves. "When you own a significant number of shares, you want to work hard and make the company prosper so you can prosper," said an employee of Global Crossing, the fiber-optic phone network, in 2001. (His hard work, unfortunately, did not keep Global Crossing from going bust and wiping out his retirement savings.)
Is It Safe?
Neuroeconomists are now exploring the forces that drive the Colonel Klink effect. The caudate area—twin curlicues of tissue, roughly the size and shape of your pinkie finger, deep in the center of the brain—may monitor the relationship between cause and effect. The caudate serves as your brain's coincidence detector. In this part of the reflexive, emotional brain, we match our actions against the outcomes in the world around us—whether they are actually connected or not. "It's not just receiving money that fires up these areas," says neuroscientist Caroline Zink of the National Institutes of Health, "but how you receive it. There seems to be a separate pleasure or arousal from feeling you did something to get it." (Perhaps it's no coincidence that the caudate is one of the brain regions most intensely activated when you learn to trust a stranger—and when you fall passionately in love.)
In one recent experiment, people tried pressing one of several buttons to earn a reward. Sometimes, they would win $1.50 if "they guessed the correct button." At other times, they could win $1.50 regardless of which button they pressed. Whenever a button press was followed by $1.50, the caudate flared into action for up to four seconds, but it was quiet whenever people perceived no connection between the button press and the reward. (See Figure 5.1.) Explains psychologist Mauricio Delgado: "Being in control—or at least believing that we are—makes us that much more invested in our actions and their consequences."
Researchers at the University of Wisconsin have shown that imagining you are in control of a