Less is more: why too much information leads to costly overconfidence

Thursday, Feb 18 2016 by
29
Less is more why too much information leads to costly overconfidence

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,…

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4 Comments on this Article show/hide all

snickers 18th Feb '16 1 of 4
8

The brain is a pattern-finding machine. It uses something like a sixth of the calories we eat while only being a small fraction of the body's volume - ie, it's working flat out all the time, seeking the thing out there which matches something we already know (or "know"). It does this below consciousness, and just reports up when it finds a match. What counts as a match, how the brain codifies and interrelates ideas, is mysterious, and may not reflect reality - hence conspiracy theories, pseudoscience, cargo cults.
To outwit your brain you need to actively analyze what you know, criticise it, shape questions about it, and go looking for answers, especially disconfirmations.

I'm not sure though that all the behaviours you list here are coming from the same place. Overtrading is perhaps not due to overconfidence, but to not having a stable theoretical base. If noticing a new pattern or theme in the world excites you too much, perhaps you haven't previously been putting in the work, to anchor yourself. That's underconfidence, if anything.
Low diversification and Over-optimistic forecasts might be the opposite problem: not getting excited enough about novelty, and being anchored too firmly in one theory. Sluggishness, if anything.
Getting excited when you (ie your brain) notices something is obviously a good thing, but the connection needs to be handled with scepticism before action is taken.

Having a checklist is a good proxy for having a theory. It's far better than nothing, but not quite the ideal, though the ideal is a very hard thing to achieve.

I don't have further advice - I'm both underconfident and sluggish - but I'm glad today I didn't sell all my shares in KBC when I excitedly noticed a done-deal takeover bid a month ago - a higher bid just came in. I had diversified my actions & not overtraded. Success!

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UK Value Investor 19th Feb '16 2 of 4
1

In reply to snickers, post #1

"both underconfident and sluggish" - I'm fairly sure that's how my wife would describe me.

Blog: UK Value Investor
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betjeman 22nd Feb '16 3 of 4

whilst under-confidence and sluggishness may not be traits highly valued by your wife I feel they are good bedfellows for a successful investing life !!

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Warranstar 22nd Feb '16 4 of 4

It is obviously true to say that trying to analyse too MUCH information is a bad for investment returns. We can't get to grips with masses of information and we lose the plot.
It is also obviously true to say that analysing too LITTLE information is a bad thing for investment returns. We may have miss something vital.
So what we need to do is to analyse the correct amount of information. It's easier said than done! However, it is not enough. We need to make sure that we are analysing the most relevant information. And, in the case of forecasts, we need to think about how much or little faith we should have in them.
I believe that the best way to get through all this is to have a defined process / whole series of questions that you must answer before you come to a decision.

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About Ben Hobson

Ben Hobson

Strategies Editor at Stockopedia. My goal is to help private investors learn and invest with confidence through the articles, ebooks and other resources we publish on site. I also occasionally bunk off to interview famous investors at expensive restaurants. I studied History at Aberystwyth University, trained as a journalist and covered business news and corporate finance before settling in as one of the first staff members at Stockopedia.  Away from Stockopedia I'm a mountain bike junkie. more »

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