More investors don’t copy our model because our model is too simple. Most people believe you can’t be an expert if it’s too simple.” – Charlie Munger
On May 14, the U.S. Supreme Court invalidated a 1992 law that prevented states from facilitating sports gambling. In other words, if a state wants to allow sports betting, it can go right ahead. Many will.
Clearly, the decision was a commentary on federal versus states’ rights, but the impact felt by you and me will more likely be on the betting side. So, with Justify seeking the next leg of the Triple Crown, the NBA and NHL playoffs in conference finals, and the Word Cup just a few weeks away, now is a great time to avail ourselves of a critical decision-making truth:
More information is not always better.
Horse racing and college football
Psychologist Paul Slovic conducted a study in 1973 to explore the effect of information on decision-making. Slovic compiled 88 pieces of information relevant to handicapping horse races – things like jockey experience, past race performance, etc. He had professional handicappers rank each piece of information by importance. From there, he had the handicappers try to pick the winners when only given the top five pieces of data for each horse. He repeated the experiment providing ten pieces of data. Then 25. Then 40.
Slovic found that accuracy (ability to pick the winner) did not increase one bit by increasing relevant information from five pieces of data to ten, or to 40. However, confidence (the subject’s belief in their ability to predict the winner) increased dramatically. Danger.
Another great example is the series of experiments run by Tsai, Klayman, and Hastie. These researchers had 106 college football team statistics ranked on predictive validity and retained the 30 top-ranking teams for the experiment. They then asked college students (with a proven understanding of the sport) to predict the winners of college football games.
For each game, the student was provided a block of six of the top 30 statistics (two of the highest validity rank, two of medium validity, and two of the lowest validity) and asked to choose the winner and provide a level of confidence. Then, a second block of six statistics was given, and the students updated their prediction and confidence assessments. This continued for five trials, such that all 30 pieces of data had been revealed and could be used in the prediction.
As you might guess after learning about the Slovic experiment, each six-pack of additional information had little impact on accuracy and a large impact on confidence (as shown in the chart below).
Source: Tsai, C. I. et al., Effects of amount of information on judgment accuracy and confidence, Organizational Behavior and Human Decision Processes (2008).
A warning (bet wisely and filter information)
The danger, as I see it, is twofold. First, in a real-world application of these prediction experiments, we would be making wagers (either on horse racing or college football). Given human nature, our wager size would correspond to our confidence. But as these experiments show, the relationship between confidence and accuracy is tenuous. Having more information doesn’t make it more likely that we will guess right (accuracy), but it does make it more likely for us to feel we will guess right (confidence).
Second, we live in an age where information is abundant. It is virtually infinite and virtually free. In many ways, it is forced on us. One needs to be active in ignoring excess information to combat overconfidence.
Building great portfolios
At MFAM, we have painstakingly whittled down the information we seek to five categories: the four pillars that define quality, as we see it, and reasonable price. (If you aren’t a regular reader, we define the four pillars of quality as: Management, Culture & Incentives; Economics; Competitive Advantage; and Sustainability & Growth.) We dig deeply to understand those elements. If data doesn’t help us refine our view on those five elements, then it is noise and should be ignored. If the data does help us refine our view on those five elements, it is information, and we should update our view – changing our minds if necessary.
We also don’t have financial TV blasting in the background or a boiler-room office setup with sales calls and trade orders being shouted. At our headquarters in Alexandria, Virginia, we have a quiet office with lots of reading nooks. Having so diligently defined what things are important to us, we work hard to actively avoid distraction.
If you are an individual investor, it is worth taking the time to clearly define what you think are the few things critical to an investment’s success. It is a challenging endeavor, but the focus affords you the freedom to double down your efforts on the few pieces of information that will drive results. Focus also blocks out the cacophony of unhelpful data that’s thrown at you daily. Our experience has led us to quality and reasonable price. Yours may lead you somewhere else.
There are many ways to invest well, but suffering from information overload is a recipe for diminishing returns (low return on time and effort) at best, and catastrophe (missing the forest for the trees) at worst.
Choosing great fund managers
If you are an advisor or a fund investor, you’d be wise to look at the existing research for what seems to matter when choosing a fund manager. This is not my area of expertise, but research supports that you should be sensitive to costs (the clear ones like loads and expense ratios, and the less clear ones like transaction costs). There also appears to be evidence that funds with the combination of high active share and low turnover perform better. There are many, many studies out there that provide unclear, but guidance on other potentially helpful factors. Just don’t overdo it.
I’m the first to admit that keeping it simple is not easy. But it works. While I do believe it matters on which factors you focus, the real magic is found in a humble and disciplined adherence to a few sensible factors over the long haul. Said this way, it properly sounds like investing, not gambling. As it should. Whether you are at the track, betting on the big game with friends, or in your online brokerage account, remember the impact that more information has on accuracy and confidence. Keep it simple.