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DENNIS DEVOURED the computer screen with an intensity he usually reserved for his trading platform. He’d just arrived in Manhattan from St. Louis for an investment banking position he couldn’t refuse, and was hunting for a two-bedroom apartment.
“These rents look like down payments,” he muttered to himself. But this was no time for complaining. Dennis checked his watch and turned on CNBC. It was the first Friday of the month and the employment report was due out momentarily.
The numbers were good—too good—and risked stoking inflation. The Dow opened down 300 points and Dennis was bereft. He’d thrown a couple of thousand into the market before yesterday’s close in anticipation of a softer jobs report. He could only grumble, “More bad luck. Last week, it was the Fed, and now this. No matter what I do, I end up the victim.”
Jasmine was up at 5 a.m. in Los Angeles in time to catch the employment news. She could barely squeeze in time for her yoga video and herbal tea. She, too, had added to her stock position the day before and was disappointed to learn of the stubbornly resilient economy.
Jasmine threw up her hands and shrugged. She’d been mistaken before, but now she would turn a negative into a positive by buying a few shares on the weak market open. Jasmine had usually been able to look beyond her mistakes, and felt this time should be no different.
Dennis and Jasmine are fictional characters, but I’m using them to illustrate a key point: Both had the same jobs information going in and yet such diametrically opposed reactions coming out. Dennis is disgusted, while Jasmine sees opportunity. What’s going on here?
People differ in how much they believe they can influence the events of their lives. Folks with a relatively strong sense of internal control, like Jasmine, see themselves as effective and able to have an impact on their life situation. External controllers, like Dennis, interpret their circumstances as largely due to outside forces like fate or just plain luck.
These personality characteristics were dubbed the locus of control by psychologist Julian Rotter back in 1954. Its universal application has been demonstrated in hundreds of studies carried out over half a century.
In the early 1970s, investigators discovered that a person’s locus of control was not monolithic. It can vary with circumstance. Reactions can depend on several situational factors, including whether the event in question was viewed as positive or negative by the person involved.
These insights contain important implications for investing behavior that, curiously, have rarely found their way into the financial media. Let’s break new ground today on HumbleDollar.
We have “internals,” like Jasmine, pondering either positive or negative events, and “externals,” like Dennis, who are doing the same. Crossing internal versus external beliefs with positive versus negative events gives us four quadrants (see chart below). Let’s fill the first box of the quadrant with an externally oriented fellow like Dennis who is given a positive market event, such as his annual brokerage statement showing only a small loss in an abysmal year for stocks.
What does he say to himself? “Boy, lucky I had to wait for those CDs to mature. Otherwise, I might have increased my stock allocation and lost more money.” Our externalizer gives himself no credit for foresight in diversifying into certificates of deposit in the first place, so he gets no boost to his self-esteem as an investor. By misconstruing positive feedback about his investment acumen as mere luck—believing it occurred without any contribution from him—Dennis may be destined for a forlorn market future.
What about the externally oriented person confronted with bad news, say a dwindling brokerage balance? Well, she blames her financial advisor. I know—because, when I was an advisor, I was often the target. She may spend a lifetime berating investment professionals, even when they’ve invested her money exactly as she’d previously requested.
Now, let’s switch sides and think of internalizers like Jasmine, those who believe they’re in control of things. We’ve all known the insufferable internalizer who proclaims he made it big “completely on his own.” At more moderate levels, he exudes confidence and approaches investing with realistic optimism.
Psychologist and Nobel laureate Daniel Kahneman stresses that an exaggerated belief in our own abilities can mushroom into overconfidence that breeds impulsive and risky behavior. Does the peripatetic day trader come to mind? An internalizer like this may believe he can anticipate the market’s random walk. As Kahneman reminds us, “We are prone to overestimate how much we understand about the world and to underestimate the role of chance.”
We are left, finally, with the case of the internally oriented individual who characteristically interprets her market misfortunes as her own fault. Who so tortured would choose to keep on investing? The Great Crash of 1929 provides her with more than enough ammunition to avoid the market altogether—and she admonishes her children seated around the dinner table to do the same.
This inclination to attribute investing failures to your own hand can be a formula for guilt and self-reproach. Meanwhile, my very first research paper in 1969 suggested that people who believe themselves unable to determine their own destiny are at risk for clinical depression.
It may be tempting to try, but please don’t start diagnosing yourself. Don’t trade in your advisor for a therapist or a prescription for Prozac, either. You may inhabit one of the four categories most of the time. But we also all hop around from box to box, depending on the specific circumstances surrounding an event.
Locus of control is a graduated dimension along which people differ, not an either-or indictment. In fact, some people have a combination of the two tendencies. They can take personal responsibility for their actions and the consequences, while also remaining capable of relying upon and having faith in outside resources.
Kahneman teaches us that self-awareness helps overcome cognitive biases like overconfidence, herd behavior and loss aversion. It can also help with our beliefs about how much we influence our life’s events. Do you feel a lot of control—or very little? The better you know yourself, the more likely you are to avoid foolish financial mistakes.
Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve’s earlier articles.
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Nice article, Steve. Your insights from psychology and behavior economics are excellent. Thank you and happy new year!
Often times I want to make this most important topic more complicated. But at this point I believe it’s simple: you take your best shot and maybe you hit the target, maybe not. If you have control issues emanating from disturbances within, it’s not an easy place to come to. Who wants to tell yourself “I am never really going to be in the results business” (It’s a spiritual truth, but imagine telling your employer that). And if you have the acumen to hit the target a lot, you may come to the point of realizing you’re not happy anyway. Which is a whole nother growth opportunity. Thanks for bringing this up.
Both of your fictional examples are terrible investors. Both sought to time the market, he by buying ahead of expected good news that never materialized and her by buying a dip in the market. Both of those are losing behaviors compared to investing the money you have set aside for that purpose immediately, regardless of market conditions. I’m glad they are fictional because they would face a rough retirement some day with that kind of decision making.
Hi, actually I actually agree with you wholeheartedly—but for two things. Unfortunately, not everyone has come to realize (like you have) the illogic and inevitable disappointments of short-term trading.
Probably I should have spelled that out more clearly. And let’s face it, I could not have illustrated the importance of internal-external control so graphically with a longer-term example!
Smart…many thanks for your professional insight.
Thank you. You brought sunshine into a grey California morning. Glad you found the article thought-provoking.