So the financial markets are all upset. Stocks began the morning with another steep slide. The media, of course, is covering the growing liquidity crisis in excruciating detail, spending lots of hours and column inches analyzing the latest rumors and sentiments on Wall Street. But here's my advice: ignore everything. Don't read the business page. Turn off the television. Go read a novel.
In the late 1980's, the Harvard psychologist Paul Andreassen conducted a simple experiment on MIT business students. First, he let the students select a portfolio of stock investments. Then he divided the students into two groups. The first group could only see the changes in the prices of their stocks. They had no idea why the share prices rose or fall, and had to make their trading decisions based on an extremely limited amount of data. In contrast, the second group was given access to a steady stream of financial information. This was supposed to be equivalent to watching CNBC, reading The Wall Street Journal and listening to experts analyze the latest market trends.
So which group did better? To Andreassen's surprise, the group with less information ended up earning significantly more money than the well-informed group. Being exposed to extra news was distracting. Instead of focusing on the important variables - the actual movement of share prices - the "high-information" students would become fixated on the latest rumors and insider gossip. (Herbert Simon said it best: "A wealth of information creates a poverty of attention.") As a result, these students engaged in far more buying and selling than the "low-information" group. They were confident that all their knowledge allowed them to anticipate the market. But they were wrong. Too much information can induce a state of ignorance.*
I think Warren Buffett said it best: "I don't use [financial] analysts or fortune tellers," he often quips. "If I had to pick one, I don't know which it would be."
* In another study, college counselors were given a vast amount of information about a group of high-school students. The counselors were then asked to predict the freshman grades of these kids during their freshman year in college. The counselors had access to transcripts, test scores, the results of personality and vocational tests, and application essays from the students. They were even granted personal interviews, so that they could judge the "academic talents" of the students in person. The competition for the counselors was a rudimentary formula that only took test scores and grades into account. All the other information about the students was deliberately ignored. Needless to say, the simple formula was much more accurate than the counselors, who were hamstrung by the excessive amount of information.
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Does the 'go read a book' advice work for performance on GREs too? I hope so.
I confess that I do follow business news, mostly because (I'm sick, I know) I find it entertaining; also, one of the subject areas I'm responsible for at my library is business.
I don't use it to make financial or investment decisions, though. That way lies second-guessing and the madness of crowds.
Actually, "go read a book" was exactly how I passed tests in college. I also didn't do more than brush up for my GRE's. Cramming and overstudying can leave you paranoid about your performance in an exam, while relaxing and taking your mind off the material can help you focus on what's important - the questions in front of you. Of course, that doesn't matter all that much if you don't know the material well to begin with.
As outperforming any financial market is a zero-sum game, it is not suprising that any increase in cost (like heavier trading) will result in decreased performance.
Although I would disagree that the actual movement of share prices was information of any importance.
I have one quibble with your investment strategy. Less information may result in better decisions in the short term, but for long-term investment strategies, the long view is clearly better than the short term.
Example- if you had bought Halliburton and Chevron stock when Cheney seized the presidency, you would have done very well over the last seven years. Perhaps you'd feel ethically tainted by your decision, but from a purely $$$$-motivated perspective, it would have been absolutely the smartest thing you could have done. Or, even better, if you had invested in a wide portfolio of narrowly-focused oil and oil-services, you could have mitigated the risk that any one company would be tainted by corruption scandals while ensuring that you could capitalize on the huge run-up in oil stocks.
As another example, if you are still holding stock in any company that is involved with home building or mortgage sales, you're an idiot. It's been blatantly obvious that Toll Bros. and HomeDepot have been headed for the rocks for the last 18 months. Every month, the news is the same- falling home prices, fewer new home starts, record lows for home sales, record highs for defaults on mortgages. All of this news points in one direction- of course, now it's too late to do anything about it, but if you had been paying attention in July of last year, you would have sold it all then and gotten out before the walls started coming down around you. Same goes for any company involved in lumber production or sales- if nobody is building houses, then nobody is buying lumber... inventories go up, profits go down, stock price goes in the tank. To make money on this trend, all you needed to do was pay attention to fed interest rates and the trends in the sub-prime mortgage market.
In a larger sense though, the point you make about overwhelming information and trading may be true- as a rule, daytraders lose money, because they trade on rumors. I would argue that the mistake is trading individual companies based on information about that specific company, rather than trading groups of companies within an industry (or market sectors) based on the easily-understandable long term trend for that sector.
A free prediction- medical device companies in the US have been going through the roof for the last 5 or 10 years. As more baby boomers get older, they're going to want more artificial knees and hips. It only makes sense that the companies producing knee and hip joints will have to grow to keep up with demand... easy money.
Unless someone like Edwards is elected and actually attempts to change the fundamental structure of paying for healthcare in this country, in which case anything could happen. But for the next three or four years, companies like Smith&Nephew and Zimmer are a pretty safe bet, as long as you diversify your risk between them so that no one company can drag you all the way down.
of course, none of this should be taken as actual investment advice. Investing carries risks, you could lose your shirt or your house, I am not a lawyer or an investment adviser, past performance is not an indicator of future earnings.
tekel:
You are forgetting about price - the great equalizer. The poor prospets for homebuilders are already in the stock prices as are Zimmers potential sales and the demographic trends behind healthcare. Because they have been whacked pretty hard, home builders may actually be the best investment at this point. Everything is relative, and beating the market is a zero sum game before costs. After trading costs it is a negative sum game. The oil service stocks perfomed well because no one could be reasonably certain that oil would more than triple in price after 2001.
Buying and selling stocks based only price pattern information is called "technical analysis". There are many variations, and it is very common. It is condemned by many finance and economics academics, since if it's any better than indexing, it implies gross market inefficiencies (people selling or buying at the "wrong" price).
In recent years, though, some have come to think that there may be "technical" approaches that add some value by acting as a proxy for behavioral finance strategies.
However, Warren Buffet is a fundamentals investor, who does NOT use "technical" approaches (he is a famous opponent of them), and who does rely on actual real life knowledge of companies and economic conditions.
So why did Warren Buffet make so much money, while the students in the short term experiment did worse using actual information than by merely using what amounted to a simplistic version of technical analysis?
Of course, Warren Buffet could have been lucky, but I don't think so. First of all the study was very short term, and second of all, the students involved were presumably inexperienced. Warren Buffet made insightful and patient use of selected information over many years. Unfortunately it would be very difficult to duplicate his performance.
Also, there could have been biasing factors. For example, the students with less information might actually have done less, since they had little "guidance" on how to act. Frequent trading has been shown to be detrimental for most small investors (to a high degree).
I wonder if the original reference is easily avaialable...
I am not very wonderful with English but I come up this very easy to understand.