There was a fascinating story recently about how scientists had detected gravitational waves caused by two black holes merging 1.3 billion years ago. One of the intriguing aspects was how the physicists, who’d spent decades searching for such a wave, managed the information in front of them. For a start they routinely dropped false readings into their data - called “blind injections” - to keep themselves focused. When a wave finally did wash past Earth, they spent a month examining whether it was a malicious hoax.
While this may sound like a world away from investing, there are actually some useful lessons here. The scientists had resisted the urge to be too confident in their data for fear of being led astray. This is exactly the same trap faced by investors, and it’s a reminder that our tendency to take comfort in lots and lots of information can end up being costly.
Too much information
Psychologists have spent decades looking at how individuals process information and how that influences our confidence. Evidence suggests that humans take too much confidence from too much information but don’t necessarily make better decisions as a result.
There have been numerous studies that show this - using subjects as diverse as bookmakers, American football fans and clinical psychologists. In each case, the research shows that in making a judgment, there’s a limit to the amount of information the human mind can usefully process. After a certain point, adding more information to the mix doesn’t always lead to a more accurate judgment. Instead, it causes us to get more and more confident about the decision we’ve made, even if it’s the wrong one.
Hazards of overconfidence
The findings of these types of psychological studies map very easily to investing. James Montier summed up the problem in his book, The Little Book of Behavioral Investing, by saying: “Too much information leads us to feel overconfident in the extreme, but it does little to aid us. But this isn’t our only problem with information; we actually find even useless information soothing and we process it mindlessly.”
As a result of the overconfidence that stems from too much information, academics have identified a handful of expensive errors that can occur:
1. Overtrading
Overconfidence in our own abilities has long been linked to chasing returns through too much buying and selling. This was a key finding in a classic study by Brad Barber and Terry Odean. Interestingly,…
