In a great book, “The Invisible Gorilla”, the authors, Christopher Chabris and Daniel Simons, write on why more information is not better information.
“Imagine that you are a subject in the following experiment, conducted by pioneering behavioral economist Richard Thaler and his colleagues. You are told that you are in charge of managing the endowment portfolio of a small college and investing it in a simulated financial market. The market consists entirely of just two mutual funds, A and B, and you start with a hundred shares that you must allocate between the two. You can put all of your shares into A, all of them into B, or some into A and the rest into B. You will be running the portfolio for twenty-five simulated years. Every so often, you will be informed of how each fund has performed, and thus whether your shares have gone up or down in value, and you will then have the opportunity to change how your shares are allocated. At the end of the simulation, you will be paid an amount that is proportional to how well your shares have performed, so you have an incentive to do as well as you can. Before the game begins, however, you have to choose how often you would like to receive the feedback and have the chance to change your allocations: every month, every year, or every five years (of simulated time).
The correct answer seems obvious: Give us information, and let us use that information, as often as possible! Thaler's group tested whether this intuitive answer is right-not by giving people the choice, but by randomly assigning them to receive feedback monthly, yearly, or every five years. Most people initially tried a 50/50 allocation between the two funds since they knew nothing about which might be better. As they got information about the performance of the funds, they shifted their allocations. Since the simulated length of the experiment was twenty-five years, the subjects in the five-year condition got feedback and could change their allocations only a few times, compared with hundreds of times for the subjects in the monthly condition. By the end of the experiment, subjects who only got performance information once every five years earned more than twice as much as those who got monthly feedback.
How could having sixty times as many pieces of information and opportunities to adjust their portfolios have caused the monthly-feedback investors to do worse than the five-year ones? The answer lies pardy in the nature of the two funds the investors had to choose from. The first had a low average rate of return but was fairly safe-it didn't vary much from month to month and rarely lost money. It was designed to simulate a mutual fund consisting of bonds. The second was like a stock mutual fund: It had a much higher rate of return, but also a much higher variance, so that it lost money in about 40 percent of the months.
In the long run, the best returns resulted from investing all of the money in the stock fund, since the higher return made up for the losses. Over a one-year or five-year period, the occasional monthly losses in the stock fund were canceled out by gains, so the stock fund rarely had a losing year and never had a losing five-year stretch. In the monthly condition, when subjects saw losses in the stock fund, they tended to shift their money to the safer bond fund, thereby hurting their long-term performance. Subjects who received feedback every year or every five years saw that the stock fund outperformed the bond fund, but they did not see the difference in variability. At the end of the experiment, the subjects in the five-year condition had 66 percent of their money in the stock fund, compared with only 40 percent for the subjects in the monthly condition.
What went wrong for the subjects who got monthly feedback? They got a lot of information, but it was short-term information that was not representative of the true, long-term pattern of performance for the two funds. The short-term information created an illusion of knowledge-knowledge that the stock fund was too risky, in this case. The monthly-feedback subjects had all the information they needed to generate actual knowledge-that the stock fund was the better long-term investment-but they didn't manage to do so.
The same thing happens in the real world of investing decisions. Brad Barber and Terrance Odean managed to obtain six years of trading records for sixty thousand accounts from a brokerage firm and compared investment returns between people who bought and sold stocks frequently and those who traded rarely. Presumably investors who make lots of trades believe that they have lots of knowledge and good ideas about stocks-that each of their trades will make money because it is anticipating a market move. But once their returns were adjusted for the costs and tax payments generated by all the trades they made, the most active traders earned one-third less per year than the least active ones.
Professional and amateur investors alike should seek the best rates of return they can get, balanced against the level of risk they are taking. Individual investors in particular may be better off paying more attention to the riskiness of their portfolios than they currently do. Earning an extra few percentage points on your money may not be worth the anxiety, lost sleep, and bad temper that can accompany the volatility of large price swings. To make truly informed financial decisions, you must have an accurate picture of the long-term returns and short-term volatility you should expect from each of your investment options, and you must evaluate these factors in light of your own ability to tolerate risk.
We are generally taught that it is better to have more information than to have less. Who wouldn't want to consult Consumer Reports before purchasing a car or a dishwasher? Who wouldn't want to know the price of a flat-screen TV at three different stores rather than just one? And in these cases, more information does make for better decisions (at least up to a point). The studies we just presented, and others like them, suggest that investors who have more information also believe that they have better knowledge. But when that information is in fact uninformative, it only feeds the illusion of knowledge. In reality, most short-term fluctuations in value are unrelated to longer-term rates of return and should not determine your investment decisions (unless you are investing money that you might need in the near future, of course). When it comes to assessing the long-term characteristics of an investment, sometimes having more information can result in less real understanding. What the Thaler group's experiment showed was that paradoxically, people who got the most feedback about the short-term risks were least likely to acquire knowledge of the long-term returns.
The illusion of knowledge can't predict the timing and magnitude of each financial bubble-in fact, knowing about the illusion should make us just as wary of attempts to predict price drops as price increases. The illusion of knowledge does appear to be a necessary ingredient for the formation of bubbles, though. Each historical bubble has been associated with a piece of new "knowledge" that was disseminated so widely that it eventually reached people who knew nothing else about finance except for that one piece of information (tulip bulbs are a can't-lose investment, the Internet will fundamentally change what companies are worth, the Dow is going to 36,000, real estate never loses value, and so on). The proliferation of information about finance, from cable news networks to web sites to business magazines, is a recipe for the illusory feeling that we know how the markets work, when all we really have is a lot of information about what they are doing at the moment, what they have done in the past, and how people think they work, none of which necessarily predicts what they will do in the future. Familiarity with the language of finance and the immediacy of market changes often masks a lack of deep knowledge, and the increasingly rapid flow of information may even shorten the cycle of booms and busts in the future.”