Are we information addicts in our investment research? “Yes,” said James Montier, the author of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy.” Writing in chapter six of his book, he said the whole investment industry is obsessed with learning more and more about less and less.
But is it better to have more?
To make his case that gathering too much information is a bad strategy, Montier turned to a study of eight experienced British bookmakers who specialized in horse racing. They received information about 45 past races in tranches of five, 10, 20 and 40 variables. Once the study was over, accuracy was highest at just five variables. In other words, the minimum amount of information produced better results than information on 10, 20 and 40 variables.
What’s more, as the volume of information and data increased, their confidence increased quite significantly—but without any improvement in their accuracy. Montier said:
“So all the extra information wasn’t making the bookmakers any more accurate, but it was making them increasingly overconfident.”
Similar results came from a study of knowledgeable American college football fans. In this case, researchers added a computer model and it processed the same data as the fans. For the computer, more data was better than less data as it continued to improve its accuracy.
For the humans in the study, though, accuracy did not increase with additional information; instead, it was about the same whether they received six or 30 pieces of information. Again, confidence levels soared, even though their accuracy remained about the same.
Financial analysts, too
Montier argued that additional information did not help humans increase their accuracy because people have limited processing capacities. While a computer can take advantage of the extra data, a human cannot.
Consider this: A group of financial analysts was asked to forecast fourth-quarter earnings for 45 companies (they did not know there were just 15 companies presented with three different levels of information). When given additional information—both redundant and nonredundant—their errors increased but their confidence ratings went up “massively.”
Checklists to the rescue
Heart patients who reported serious chest pain at the emergency room of a hospital in Michigan were being sent to the cardiac care unit too often, according to research cited by Montier. As a result, the unit was overcrowded, standards of care were falling and costs were increasing. It was also a problem for patients, who were more likely to contract a hospital-transmitted illness in the cardiac care unit than in a conventional ward.
Research into the situation concluded that doctors were gathering too much information, including a long list of family and previous conditions (termed “pseudo-diagnostic” items). Other research identified a short but effective list of real diagnostic conditions: including the nature of the symptoms, history of ischemic disease and “certain specific electrocardiographic findings.”
To help doctors focus on the correct items, the researchers provided laminated cards with specific diagnostic information and the probabilities associated with them. That allowed doctors to multiply the probabilities against the symptoms and get an overall rating, which in turn would determine whether patients went to the cardiac care unit or a conventional ward with heart monitors. That produced a “marked” improvement in the decision-making of the doctors.
Researchers then followed up by giving doctors the decision tool some weeks and withholding it other weeks (the tool was complex enough that doctors would not be able to simply memorize it). But whether they had the tool or not, doctors were making better decisions. Montier described the results this way:
“In fact, the doctors had managed to assimilate the correct cues. That is to say, by showing them the correct items to use for diagnosis, the doctors’ emphasis switched from pseudodiagnostic information to truly informative elements. They started looking at the right things!”
Based on what they had discovered, the researchers created a simple yes/no checklist. For example, if a patient had “a particular electrocardiogram anomaly (the ST change),” they were sent to the cardiac care unit right away. If not, the doctor moved down to the next item on the checklist and so on. The result was far better diagnoses, more effective use of the care unit and fewer patients exposed to hospital-sourced illnesses.
Checklists for investors
Montier cites Jean-Marie Eveillard of First Eagle Investment (Trades, Portfolio) as saying:
“It’s very common to drown in the details or be attracted to complexity, but what’s most important to me is to know what three, four or five major characteristics of the business really matter. I see my job primarily as asking the right questions and focusing the analysis in order to make a decision.”
Calling himself a deep-value investor, Montier says his checklist focuses on three elements:
- Valuation: Is this stock significantly undervalued in relation to its intrinsic worth?
- Balance sheet: What are the odds of this company going bankrupt?
- Capital discipline: Is management making good use of the capital they have received?
Looking beyond Montier’s book, GuruFocus readers have access to many articles about checklists by doing a search for the word under the "Articles" tab. Among them is my recent article on the checklists used by Peter Lynch: His all-in-one checklist included seven items he considered essential.
Conclusion
Perhaps it’s our hopeless attempt to know everything about a potential stock, or perhaps it is a rationale for delaying a decision, but information overload is a problem for many human investors.
In chapter six of "The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy," Montier took us through several research projects that found having more information was not helpful in making good decisions. Indeed, it might be called one of our worst enemies. From British bookmakers to American emergency room physicians, less was better.
The other side of too much information is that it increases false confidence; more confidence without increased accuracy. And overconfidence is likely to lead us to make bad decisions, just as information overload does.
But how do we focus on the essentials and avoid being being pulled into nonessential information and data? That, argued Montier, can be achieved with the use of checklists.
From this reviewer’s perspective, before analyzing a stock, decide on which criteria are essentials, create a checklist that incorporates them and then be disciplined in working through the list. For many value investors, such a checklist might include earnings, free cash flow and margin of safety. Of course, each of those three checklist items would need to be unfolded to get at the underlying data.
About Montier
The book's author is a member of the asset-allocation team at GMO, the firm founded by Jeremy Grantham (Trades, Portfolio) in 1977. According to his Amazon profile, he was previously co-head of global strategy at Société Générale (XPAR:GLE, Financial). The author of three books, he is also a visiting fellow at the University of Durham and a fellow of the Royal Society of Arts. The book we are discussing was published in 2010.
(This article is one in a series of chapter-by-chapter reviews. To read more reviews of other important investing books, go to this page.)
