Humans hate uncertainty. Uncertainty is stressful. Often it is even more stressful than a certain negative outcome. The reason we find uncertainty so stressful is so it prompts us to take action. When our ancestors weren’t sure if a predator was lurking nearby, the ones that got a bit stressed out by the idea and took steps to find out probably did better than those that blissfully carried on their business regardless. But like many other evolutionary instincts, the desire to reduce uncertainty can lead us astray when it comes to investing.
One way we can attempt to avoid uncertainty is to seek out as much information as we can. In many ways this is a sensible thing to do. In principle more information should allow for better decision-making, as anything that is not relevant can be disregarded when ultimately making a decision. However, a lot of research has found that in practice too much information often has the opposite effect. The way information is presented to us, the time when we receive it and the effort we put in to find it can all affect our decision-making very materially, even though it should not.
This is captured well in the following interesting experimental research: on the pursuit and misuse of useless information. In it students were asked to make a series of decisions based on information presented to them. In some cases they were provided with all the information immediately. In other cases they were presented with just part of the information and given the option of seeking out the rest of the information before making their decision.
For example, students were asked if they would take a one-off opportunity to register for a course with very interesting subject matter. They were told that the course was normally taught by a professor with an excellent reputation, but that a less popular professor would be teaching the course this time. When provided with all of this information up front, 82% of students said they would take the course, despite it being with the less popular professor. When asked about the same course, but told they would need to wait a day to find out if the popular professor would teach the course or not, the majority decided to wait to find out (even though most of them should have been willing to take the course regardless). When they had waited for this information and it was revealed the less popular professor would be teaching, a significantly lower percentage (71%) ended up opting to take the course than when the information was provided up front.
The authors generate similar results from a series of similar experiments across a range of contexts. Overall, they find that people are biased to seek out superficially relevant but ‘non-instrumental’ information that, had it been directly presented to them, would not have affected their decisions. However, once they take action to seek out this information, it then does end up affecting their decisions.
Information overload and investing
This is obviously highly relevant to investing. Investors are faced with huge breadth and depth of apparently relevant information sources, ranging from in depth historical accounting information and annual reports to meetings with management and the views of other investors on bulletin boards. There is far more information out there than most investors could practically use.
Investors are highly motivated to seek out and use all of the available information to reduce the uncertainty of their investments. However, beyond a certain point much of the uncertainty simply can’t be reduced in practice, no matter how much information is used. The future prospects of a business are determined by such complex processes and interactions that they are effectively inherently unpredictable. Even the huge array of information available to investors is only the tip of the iceberg of what would actually be needed to predict outcomes with a materially greater degree of confidence. Investors are also simply not capable of processing all the data points required to accurately predict such a complex system.
The result is that investors use a lot more information than the few key aspects that are most predictive of an investment’s future success. Much of the information investors use actually has very low predictive power – in a practical sense it is irrelevant. As the research above showed, irrelevant information is not always benignly disregarded. Even when we are prepared to acknowledge its irrelevance in certain contexts, it can still affect our decision making in others.
Detailed research tends to be regarded as inherently virtuous by investors. It is not. Excessive research into an investment can often do more harm than good. While a certain amount of information is necessary, irrelevant information increases the scope for mistakes and may often bias our decision-making.
The most common and important type of mistake is simply the bias from placing too much weight on information that is of limited relevance. Broadly speaking, too much information can make us lose sight of the big picture and instead focus on specific details. For example:
- We have a tendency to place more weight on information we have recently received or on aspects that have recently changed, relative to the information we have had for longer, regardless of its actual importance.
- We have a tendency to place more weight on information that we have had to put effort in to find or analyse. We have a subconscious desire to justify the effort. The effort could just be a small degree of additional inconvenience, such as having to wait.
- We have a tendency to place more weight on information that supports our existing prejudices and to disregard information that contradicts them – confirmation bias.
The more information we look for the more we are susceptible to these biases.
The more insidious effect of gathering too much information is that it can lead to the illusion that we have reduced uncertainty much more than we actually have. Overconfidence can lead to excessive conviction. Believing there to be less risk than there is, we may concentrate too much of our portfolio into a single position or be reluctant to sell even in the market turns against us. It is all too common for investors who feel they know a company inside out to become overly confident that nothing will go wrong.
Overconfidence in one’s understanding of the relative prospects of different businesses can also lead to overtrading. We are more likely to overreact to new information if we have an excessively high degree of certainty in what the information we already have implies.
What steps can investors take to deal with information overload and the biases it can bring?
Develop an analytical framework
The most important way of dealing with abundant and diverse sources of information is to have an analytical framework for processing it. The analytical framework tells you what questions you need to answer to predict an investment’s likely success. This in turn tells you what information to prioritise, what to discard and how to interpret it. A well-structured framework can massively increase your capacity to handle detailed information while minimising the potential for it to bias your decisions.
What I do in my day job is similar to investing in that it involves making decisions under considerable uncertainty and complexity, while relying on abundant and diverse information sources. My experience is that a much more common and important error is to approach a problem in fundamentally the wrong way, rather than to incorrectly analyse the detail of the data. If you don’t ask quite the right questions, you can be wildly wrong no matter how sophisticated your analysis. If you do ask the right questions, then you are much more likely to be right, often even if you rely more on intuition rather than detailed evidence.
Creating a decent analytical framework that asks all the right questions is much easier said than done. It needs to effectively prioritise the really important questions and not leave any major blind spots. It needs to be logically structured to capture the links between different questions and to avoid duplication. It needs to be sufficiently simple that it is practical to apply, for example with a short checklist.
If you create a good analytical framework you can then apply it to every investment. Doing this is basically the same thing as clearly defining a systematic strategy. In many ways, I think this is the most important thing an investor can do to be systematically successful over the long run. You can see what I have come up with by browsing through my blog…
Shut out the noise
If you want to avoid being influenced by irrelevant information, it helps if you can muster the discipline to shut it out. You can be pretty confident that you won’t lose much by completely shutting out certain sources of information. For me this is mainly online bulletin boards, the mainstream media (particularly macroeconomic news) and detailed analysis of company accounts (something I used to get bogged down in a lot).
There is plenty of scope for disagreement on exactly what information is pertinent and what is irrelevant. It partly depends on your strategy – this is the point of having an analytical structure. My point here is just that it helps to be selective in choosing your information sources and to do this effectively requires discipline.
As well as having a clear analytical framework, I think it can help significantly if you put in the effort to make sure your thoughts and analysis are captured in a well-organised way. Having your previous thinking clearly set out should reduce the risk that your decisions are disproportionately biased by new information.
I use a host of tools to help me organise my thoughts and decision-making. I find Stockopedia very useful for quick, clear access to the financial information of the shares on my watchlist and of course I record the thinking behind my trades on this blog. I find it very useful to have this in front of me when I review my existing investments or am contemplating a new one.
This is one of the best pieces about investing I have read in a long time, thank you. At least it is one I agree with so will give it extra importance in my mind.
I have been running my own investment portfolio for around 4 years now (as a serious endeavour/business) and a few years prior to that (in a less serious way/hobby) and work in finance. Whenever I speak with anyone in this industry about it and go through my process everyone looks at me like I am crazy / stupid if I am honest about saying I keep to the relatively small number of what I think are key aspects about a share (QVM from Stockopedia takes you quite a long way in my view); however if I say I go into all sorts of detail with the financial accounts, read extensively around a company’s management etc. they look at me with respect.
It is like everyone in the industry has read Ben Graham’s “Security Analysis” and thinks more digging into the financials is always better, no matter how spurious the extra information is.
My theory is that this is part of the mystique that the Asset Management industry has built up around itself to convince ley people that they could not possibly manage their own money. If someone looks like they are doing so successfully they can always throw some additional financial ratio at them (Sharpe, diversification etc.) and therefore say they are being “risky”, which seems to be another word for stupid in this industry.
Checklist of key attributes and write down your logic at purchase and each review basically covers it for me too.
Thank you for the comment Peter
It sounds like you have a similar experience of and approach to investing as I do (well at least at a high level). I’d be interested in hearing more about your approach and what you think of mine, if you were so inclined. I wish you much success!
I don’t work in finance so I find it reassuring to hear my perception of it confirmed by someone more ‘on the inside’. In my industry (competition economics), which involves to some extent similar types of issues and analysis to investing, there is also the tendency to get bogged down in spurious detail without devoting sufficient attention to the big picture or logical framework required to answer the main question (and to see this misguided effort as in some way virtuous).