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Do you really need to know more?

Do more inputs lead to better investment decisions? The answer is a lot more interesting (and useful) than you would expect it to be

Do you really need to know more?

Some years ago a study showed, quite unambiguously, that individuals who scored high on financial literacy did worse as investors compared to those who scored low. And then there was another study by a very large US-based investment advisor/broker that showed that their best-performing accounts belonged to people who happened to have died at some point. Another study showed that having more data did not improve the predictive abilities in a wide range of fields. That's not all. Anecdotally, almost every investment advisor knows that individuals who follow news and events closely tend to make hasty investment decisions and which come back and bite them.

These are all themes that I have written about at various points of time. However, there's a common thread here which is not hard to follow: Widely accepted characteristics of what constitutes a smart investors may be profoundly incorrect. In fact, they may well be the exact opposite of the truth. We accept that investors should be financially literate. We accept that they should be aware of what is happening around them, to be aware of the environment. And we accept that they should act upon this knowledge. Unfortunately for conventional beliefs and wisdom, ALL of these may have a negative correlation with investment success.

In fact, this should leads us to should question what exactly do we mean by terms like financial literacy and investment knowledge. In Fooled by Randomness, Nassim Nicholas Taleb quotes what he calls 'Wittgenstein's Ruler', named after the Austrian philosopher Ludwig Wittgenstein, "When you use a ruler to measure a table, you are also using the table to measure the ruler." In this light, consider the study that discovered that 'individuals who scored high on financial literacy did worse as investors...' Perhaps what it actually discovered was that the conventional idea of 'financial literacy' are wrong. It's not the table that is built wrong, but the ruler that is faulty.

Somewhat similar is the concept that the idea being well-informed and acting expeditiously upon a large set of inputs will enhance your investment returns. The dead investors example above counteracts that quite nicely. Dead people do not absorb more information nor do they act quickly. And yet they made more money. Very likely, they made more money precisely because they were doing nothing.

What is the explanation of all these observations? To me, the most interesting part is that what seems to have been discovered is not that financial literacy or more news was uncorrelated to investment performance but that it was negatively correlated. It's possible, even likely, that for many people, these things actually harm investment returns.

The third study above, 'Effects of Amount of Information on Judgment Accuracy and Confidence', has an interesting explanation. It showed that when people have more information, their confidence in their judgement increases more than the judgements' accuracy. That's a most interesting phenomena and if you think about it, it is essentially a definition for overconfidence. Let's say you have an understanding of something based on five inputs. Maybe your conclusions are correct, maybe they are not. However, if you get five more inputs, your likelihood of making a better judgement of the situation increases very little, but your confidence in your judgement increases a lot. In other words, you become overconfident.

So let's try and map this learning to what happens to individuals who are investing. Some of them make good decisions and some bad decisions. However, those investors who have more inputs (or knowledge) tend to act upon their judgements more, regardless of whether those judgements are good or not. Now let's apply this idea on a population scale--to all those who are making investors. As more and more of them start absorbing more inputs--whether TV or newspapers or social media or whatever else, there will be a net increase in people making investing mistakes. Is this happening? I think it is.

I'm not offering any broad solutions here. However, at an individual level, it's probably good to realise that there is an optimum level of information one needs. More than that could be just as harmful as less.