It’s normal to want as much information as possible before making a decision -- particularly an investing decision that involves your personal wealth. But will having more information yield better outcomes? Not necessarily; in fact, too much information may have the opposite effect.
What we can learn from used-car buyers
In a widely cited study showing the impacts of information overload, researchers tested whether car buyers make better decisions when given more information about the cars that they're selecting from. The study required subjects to choose among four cars, one of which was clearly better than the rest (75% of its attributes were positive), one which was clearly worse (75% of its attributes where negative), and two which were right down the middle (the attributes were split 50-50).
One group of subjects was given just four pieces of information about each of the cars, while a second group was given 12 pieces of information. Which group do you think had a tendency to choose the best car? It was the former. The people who were given only four attributes of each car chose the one that was clearly better than the rest 60% of the time. Meanwhile, the people who were given 12 attributes only selected the best car 20% of the time.
The conclusion? While a certain amount of information is necessary, too much can have a deleterious effect on the outcome because it muddies the decision-making process. To put it slightly differently, an overload of information makes it difficult for people to delineate between the "signal" (what really matters) and the "noise" (what doesn't matter).
The inverted "U" curve
I thought about this recently when reading Malcolm Gladwell's David and Goliath: Underdogs, Misfits, and the Art of Battling Giants. The book presents a number of situations where having more of something can be counterproductive. Among others, there's the namesake story of David and Goliath, where having more size ultimately worked against Goliath, and there's an anecdote about a wealthy father trying to raise humble and ambitious children. In both cases, strengths were transformed into weaknesses via abundance.
To illustrate the point diagrammatically, Gladwell introduced readers to the so-called "inverted 'U' curve," which I've recreated to show how too much information can produce suboptimal investment returns.
If you've taken a microeconomics course at some point in your life, this may look familiar. To the left of the vertical dotted line, you can see that more information does in fact produce better investment returns. But each additional piece of information yields less marginal utility -- this is known as the law of diminishing returns -- and, at some point, additional information begins to have the opposite effect. You can see this by the negative slope of the curve to the right of the vertical dotted line.
But this is theory; is it also true in reality? The answer, it turns out, is yes.
Is stock research harmful to your wealth?
In a variation of the study about car buying, researchers looked into whether having more information led to better earnings forecasts among financial analysts. And as you may have guessed, the result was the same. More information led to less accurate forecasts -- and higher confidence, but that's another story altogether.
Given these findings, it's tempting to conclude that researching stocks is a fruitless, if not harmful, exercise. And to a certain extent, this can't be denied. It's been proven on multiple occasions that the vast majority of investors would be much better off buying an exchange-traded fund that tracked the S&P 500 (SNPINDEX:^GSPC) rather than investing in individual stocks.
But this conclusion misses the point. The lesson, according to James Montier in The Little Book on Behavioral Investing, is not that investors shouldn't select individual stocks. It is instead that investors should "focus on what really matters, rather than succumbing to the siren song of Wall Street's many noise peddlers." This is admittedly a nuance, but it's a critical one. "We would be far better off analyzing the five things we really need to know about an investment," Montier went on to explain, "rather than trying to know absolutely everything about everything concerned with the investment."
The takeaway, at least for me, is that investors should in fact dedicate time to researching stocks. But that time should be directed toward learning the handful of things that really matter as opposed to every tiny detail that can be dug up in a company's filings.
John Maxfield has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.