A few days ago, I read an interesting article by an American security expert named Bruce Schneier. He is a cryptographer and computer security specialist who has evolved into a thinker and writer about all kinds of risks and security. I find it very interesting that some of his ideas about risk and human reactions to it have great relevance to investing. A couple of years ago, I wrote about how people tend to overrate the risks they face from rare but dramatic events and underestimate those from mundane everyday risks.
Schneier talks about a 'Control Bias' where we tend to underestimate risks in situations where we are in control, and overestimate risks in situations when we are not in control. The most common example is the fear of flying vs the perception of risk while driving. There's clear evidence that flying in a commercial airliner is by far the safest mode of transport that there is. In contrast, Indian roads are quite unsafe. Yet, many sensible people have a deep fear of flying but are quite unconcerned about driving.
Worse, people take slippages in risk levels on the road unthinkingly. They chat on their phones while driving (it's not unusual to see two-wheeler riders type SMS messages while driving); they drive after having had a couple of drinks; they drive when they know their brakes or tyres are not good; they overtake while turning and so on. Yet, they are scared of flying. All these could be examples of ‘Control Bias’.
When we are doing something ourselves, we have an illusion of control. We underestimate risk because we are in possession of all the facts and we feel that we can control the situation when in reality we can't. When flying, we really don’t know what’s happening so we do not have the illusion of control.
I find that this false impression of control is exactly what make people underestimate risk while investing. It is a fact that most people don’t know enough to be dabbling in stocks. Yet they do so because they have a large amount of information which makes them believe that they know enough to be in control of the situation. Someone sells investors a story about why a stock will do well and the story appears to have enough information to give an adequate illusion of control.
This is also the reason why many genuinely knowledgeable investors advise even newbies against investing in mutual funds (MFs). These people have enough information of stocks but feel inadequately informed about what is going on if their money is in a MF. The fund investment manager is like pilot and you don’t know what he’s doing.
Unfortunately, investing also has its equivalent of driving drunk or without good brakes and tyres. Almost no individual stock investor follows any systematic risk-control on their portfolio. They don’t diversify properly. They allow their portfolio to have odd concentrations in one or two stocks or sectors and they don’t track exactly what is happening with the stocks they have already bought. The fact that they are doing things themselves gives them the illusion that they know what’s happening and if the situation gets tricky they’ll manage to get out of it.