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, their analysis of 35,000 trading accounts found that men trade more than women; the annual turnover rates of men were about 80%, while those of women were 50%. Both men and women earned poor returns as a result, but men performed worse.

They concluded: “We believe there is a simple and powerful explanation for high levels of trading on financial markets: overconfidence. Human beings are overconfident about their abilities, their knowledge, and their future prospects.”

2. Low diversification

Another consequence of overconfidence is a willingness to hold too few stocks in a portfolio. This was a finding in a 2008 study of more than 60,000 US trading accounts by Alok Kumar and William Goetzman, which noted that ‘a large proportion’ of investors were under-diversified. Among a number of reasons for this, they identified overconfidence and being a contributing factor. You can read up on some of our previous articles on this subject here and here.

3. Over-optimistic forecasts

A third potential problem caused by overconfidence is one highlighted by David Dreman, who has written at length on the perils of information overload. As a contrarian value investor, he points out that in times of complexity and uncertainty, investors - both professional and individual - demand more and more information to help guide their decision-making. As a result they become over-optimistic in their forecasting, which in turn is a reason why so many people buy stocks that analysts recommend.  

In Contrarian Investment Strategies - The Psychological Edge, Dreman says: “Respect the difficulty of working with a mass of information. Few of us can use it successfully. In-depth information does not translate into in-depth profits.”

Incidentally, Dreman’s response was to create contrarian strategies that focus on buying cheap stocks that are unloved by the market but still have reasonable quality characteristics. You can see the Dreman strategies tracked by Stockopedia here.

Keeping it simple

Given that the stock market has got off to a sluggish start in 2016, it’s not surprising to see increasingly frantic news and updates coming from analysts and commentators. But it’s worth remembering that when it comes to processing reams of information, less might be more.

There have been numerous studies in this area (far more than I could ever hope to have processed, I now discover!). However, the key lesson seems to be that attempting to absorb too much information can lead to overconfidence and the familiar investing errors of trading too much, holding too few stocks and relying too heavily on forecasts. So it pays to tune out from market noise, particularly in periods of volatility when others are losing their heads.

Last week I wrote about how a checklist approach to a portfolio could be useful starting point to dealing with a down market. You can also check out Ed’s article on facing down the beast of volatility here.