The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Wednesday, July 18, 2007

Do Investors Have Too Much Information?

A recent Buttonwood column (July 12) in The Economist magazine made the case for the idea that investors may have too much information to make good financial decisions. As the late, great Fischer Black pointed out, much of the 'information' -- whether they be news items, data, or even valuation models -- that is consumed by financial decision makers are essentially noise. As the article suggests, an increase in the amount of noise (in the guise of information) that investors are exposed to increases the level of confidence in their investment decisions. Unfortunately, this 'confidence' is over-confidence; various studies in the social sciences have pointed out that having more information does not correspond to improved performance in decision making and/or prediction of uncertain events.

This problem is referred to as 'noise trading' (I believe Fischer Black was one of the first finance intellectuals to rigorously study this idea). The ways investors try to 'solve' the problem of financial decision making in the midst of noise often lead to anomalies that are the bane of neoclassical financial economists (but are a boon to their 'behavioralist' brethren). For example, one study Buttonwood cites found that American mutual fund managers tended to favor investing in companies where senior officers went to the same universities as they did. Obviously, this is a silly and simplistic 'solution' to a complex problem, but silly and over-simplistic heuristics are what human beings often gravitate towards in the face of complexity.

Buttonwood suggests that a better solution to the problem of noise trading would be to exercise discipline in financial decision making. Rather than (over-)reacting to the latest bit of news on the financial wires, take the information (usually, noise) with a grain of salt and base decisions in a more equanimous manner. Sadly, this is easier said then done.

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