Cognitively Yours 1.18

 

Raja R, Author

"We should be far better off analysng the things we really need to know, rather than trying to know absolutely everything concerned with the investment."

In the last blogs, we saw how, when the number of choices grows further to the extent of choice overload, the negatives escalate until we become overloaded. Also, we saw how a choice architect by means of nudges could help people choose.

The other obsession is information overload. Especially when it comes to investing, we seem to be addicted to information. “The whole investment industry is obsessed with learning more and more about less and less, until we know absolutely everything about nothing”. We are not worried how much of these information is really required for decision making and we are hounded with so much information that we are unable to distinguish the signal from the noise.

We have seen in post 1.2, in a study by Richard Thaler, how the asset allocation becomes sub-optimal when the frequency of portfolio information is increased from ‘once in five years’ to ‘once a month’. More information in that study created an illusion of knowledge that led to less understanding. The belief that more information must be better stems from the notion that, if the information is of no use, it can be ignored. However, psychological studies cast doubt on the soundness of this seemingly innocuous belief.

A group of psychologists tested football fans to predict the outcome and point spread in 15 games. The participants are experts. The information was presented in a random order over five rounds. Each round revealed six items of information randomly. The items covered a wide range of statistics such as fumbles, turnover margin and yards gained.

A computer model was given the same data as the humans. In each round, the computer model was given more information, replicating the conditions the human players faced. With the first set of information, the computer model was about 56 per cent accurate. As more information was added, the predictive accuracy rose to 71 per cent. More information is definitely better for computer.

The football experts’ accuracy didn’t improve with additional information. It didn’t matter whether they had 6 or 30 items of information, their accuracy was static. However, the participants’ confidence soared as more information was added - they were 69 per cent confident with 6 pieces of information and 80 per cent confident when they had 30 items of information. But, their accuracy did not show any improvement.

A similar outcome was found among financial analysts as well. Their task was to forecast the fourth quarter earnings in 45 cases. They were 15 firms, but each firm was presented in one of three information formats. The formats were:

1. Baseline data consisting of the past three quarters of EPS, net sales, and stock price.

2. Baseline data plus redundant or irrelevant information.

3. Baseline data plus non-redundant information that should have improved forecasting ability.

Each respondent was not only asked for his or her forecast but also for their confidence in their forecast. Both redundant and non-redundant information significantly increased the forecast error but the self-reported confidence ratings for each of the forecasts increased massively with the increased amount of information available.

Message: It is far better to focus on what really matters, rather than succumbing to the call of many a noise peddler. 

We should be far better off analysing the things we really need to know about an investment, rather than trying to know absolutely everything about everything concerned with the investment.

Any investor who wants to invest in a mutual fund on his own is similarly overawed by the information available. If he visits any website and compares the performances of mutual fund schemes, in his endeavour to invest in the best, he is unable to decide due to the amount of information available. The performance chart shows various schemes categorised under different categories, their performances over different time periods, the  expense ratios, concentration in top stocks and scores of other information. An information shows a fund as top performing in the one-year time horizon but average in some other time horizon and below average in a different time horizon.

We, humans have limits on our ability to process information and aren’t super computers to carry out massive amounts of calculations in a limited time. Our brain’s processing capacity is very limited.

Jean-Marie Eveillard of First Eagle says “It’s very common to drown in the details or be attracted to complexity, but what’s most important is to know a few major characteristics of the business really matter. I seem my job primarily as asking the right questions and focusing on the analysis in order to make a decision”.

Warren Buffett also echoes similar sentiments, “We just try to buy businesses with good-to-superb underlying economics run by hones and able people and buy them at sensible prices”. 

The approach to investment be it in stocks or on mutual funds is to focus on a few factors and evaluate them always when making an investment.

The elements to be focused while investing on stocks for a value investor may be

1. Valuation: Is the stock undervalued?

2. Balance sheet: is this stock going bust?

3. Capital discipline of the company.

Before choosing the mutual funds one may have a check list

1. Investment objective of the fund - whether it suits my risk profile and investment horizon

2. Performance of the fund over a period of sufficiently long time across market cycles as compared to benchmark as well its peers

3. AMC track record

4. Scheme’s assets under management.

One can argue on these parameters but the important take-away here is that one should have a check-list of the factors one will use to assess one’s investment choices, and then focus on one’s own analysis of each of these factors. Then, investment will not only be simple but also easy. 

Reference: The Little book of behavioral investing by James Montier.

Photo credit: @snowing - www.freepik.com (edited)