A lot of knowledge can be a dangerous thing. New research shows that too much information, and the way our brains process it, can hamper our investment per-formance. Zilla Efrat reports.
A lot of knowledge can be a dangerous thing. New research shows that too much information, and the way our brains process it, can hamper our investment per-formance. Zilla Efrat reports.
Twenty five years ago, the would-be stock investor had, at best, access to annual reports, some stockbroker research and advice from a stockbroker. These days, however, one can tap into to ove r 100 million pieces of investment data at any time over the Internet.
Times have changed and the changes pose a dramatic challenge to advisers and their clients, says Philip Fortuna, managing director of the US-based Scudder Kemper Investments, which is part of the Zurich Financial Services Group.
He says there has been an information explosion which the human brain hasn’t quite been able to master. “Research has shown that too much information leads to bad decisions. The more information people get, the worse their decision making gets,” he says.
Indeed, research in the United States by Brad Barber and Terrance Odean, both business school professors at the University of California at Davis, suggests that the way in which equity investors act is anything but rational.
The more they know — and the more they trade — the more they underperform the market and, even worse, themselves. In fact, active share trading can be hazardous to their wealth.
In what is believed to be the largest study ever done on investment habits, Odean and Barber were given unlimited access to the records of a discount broker cover-ing 66,465 US households, which together had traded $4.5 billion in shares be-tween 1991 and 1996,
Fortuna says discount brokerage clients are meant to be fairly sophisticated. They are usually highly educated and mostly high net worth individuals.
But, over the five year period, these individuals earned 16.4 per cent a year on their equity trades while the market gained 17.9 per cent a year.
Odean and Barber also found that those people who kept their portfolio exactly as it was at the start of the year, did better than those who traded their shares.
The non-traders underperformed the index by only 0.1 per cent a month. And, they performed a quarter of a percent better each month than they would have if they had actively traded.
Other research by Odean and Barber reveals that the investment performance of a sample of people dropped after they switched from phone trading to more active on-line trading between 1991 and 1996.
Their gross returns underperformed the market by 1.2 per cent and they were left 4 per cent worse off than if they had simply held their original portfolios.
The message, it seems, is that trigger-happy traders are prone to shooting them-selves in the foot. And, according to Fortuna, this is because they react to all the noise out there, buying and selling on every flip and turn in the market.
“Our brains have been hard wired to behave in a certain way over a million years. In the old days, people had to be good at finding out new and better information to progress, but now, they have to be good at filtering out information,” he says.
He adds that our data filtering skills are hampered by various factors. One is our selective perception which allows us to see only a fraction of what is actually out there. Another is the human habit of processing information in sequence which has taught us that the most important piece of information is the most recent one.
“This makes us pattern seekers. It also makes us see patterns that don’t exist,” says Fortuna.
“We are also non-optimal calculators. We are not computers and our minds are lazy, so we come up with simple rules of thumb. We also have limited memory ca-pacity and we often remember the past wrong,” he says.
The result, he says, is that we become bad forecasters, making our predictions, based purely on the information available to us, without asking for what isn’t there.
We also anchor or fix on the present and make small adjustments for the future. Because of this, we often buy shares that have already run up in price.
“Investors look at the top of the pops and expect these to continue into the future,” Fortuna says.
We also fall victim to what he calls “the illusion of control”. “We think that in-vestment results are a lot more predictable than they really are. We have a poor sense of randomness and we see patterns where there are none,” he says.
Fortuna believes these human frailties extend to fund managers too and he advises financial planners to make sure that the managers they recommend are trying to deal with these kinds of issues. If not, he says the noise could overwhelm the man-ager’s skills.
He also advises against relying on short-term performance tables and says a long term track record should always be requested before investing in managed funds.
“There’s a lot of noise in the one and three year performance charts. There’s a lot less in the five year figures and even less over, say, seven years,” he says.
Fortuna says financial planners should avoid funds with high tracking errors, be-cause tracking errors measure the noise.
“If a performance is good and the tracking error is high, the odds are that the fund got there by chance,” he says.
“Clients should also be encouraged to get rich slowly. If they try to get rich too quickly and they jump on to every fad, they will underperform.”
He adds: “If I were an adviser I would advise my clients not to read the financial pages of the newspaper. This is because much of what the press does is to report the noise.
“If clients wants to make an investment, tell them to sleep on it overnight. If they still want to, tell them to wait a little more. Only let them invest after they have spent a number of days thinking about it. In this way, you can stop them from re-acting to the noise.
“Their investments should be long term anyway, so waiting a few days isn’t going to make a big difference even if the price is rocketing. After a while the price will come down. Good things always come to those that wait.”
