The Handicapper's Fallacy: Unraveling the Myth of More Data, More Success

This past weekend marked the conclusion of the 149th Kentucky Derby, a renowned event called the "Run for the Roses" and the "Most Exciting Two Minutes in Sports." During this time of year, I am reminded of a 1973 study by Paul Slovic — coincidentally, that’s the same year Secretariat won the derby in a still-standing record-setting fashion. The important study showcased the influence of information on horse bettors, which is also relevant to investors.

In the study, professional handicappers ranked 88 pieces of the available information in order of importance to their horse selection process. Then they were tasked with predicting the outcomes of undisclosed races, starting with just five pieces of data and gradually increasing to 10, 20, and 40 in the order of their preferences.

It'd make sense that more information would lead to more winning bets — I call this the handicapper’s fallacy. In actuality, the accuracy of the handicappers was consistent, whether armed with only a few data points or a large batch. But one thing did change — the participants became more confident in their strategies when they had more info. 

Slovic's study is worth revisiting today, in the age of information. The sayings "knowledge is power" and "data is the new oil" are frequently used to highlight the growing role data is taking in society. Some celebrate data as humanity's future. Others warn of its potential to cause our downfall. But most agree that data’s role in our lives is growing.

The hailing and fearmongering crosses domains from healthcare and education to art and investing. As an investment manager and financial advisor, I can understand both perspectives. On the one hand, data tools aid me in making investment decisions and analyzing important financial choices for my clients. But I've seen firsthand how data can be used to support poor investment decisions or lead investors to overcomplicated (and ineffective) strategies. It's important to consider the balance between helpfulness and potential harm. 

When does an overload of data become counterproductive?

I just searched for "investment strategy 2023" on Google — it returned 6.83 billion results in just half a second. Don't worry; I don't rely on such searches to inform my recommendations. Every imaginable investment strategy, along with many unimaginable ones, is represented in the results of that query. Many are nonsensical, surefire ways to separate an investor from her wealth. Stock tips inundate inboxes and social media, and the news makes it difficult to separate the signal from the noise.

The digital economy has grown over the last several decades from novelty to cog in the global economy. It brings many potential benefits like social connectivity, educational opportunities, global communication, and automation. But sometimes less is more. 

For investors, it's tempting to believe more data points lead to better investment decisions. With the abundance of resources available to investors, such as corporate earnings, annual filings, analyst recommendations, and technical analysis, one would assume that the quality of decisions and performance has improved. Is this truly the case?

In Carl Richards' book, The Behavior Gap, he explored why there’s a difference between what we know we should do and what we ultimately do. Blaming the economy and corporate greed may seem like an easy way out, but Carl realized that it’s our choices that lead to underperformance and money trouble. The term behavior gap was thus coined to identify how our behaviors lead to underperformance.

If Richards is right, and I think he is, additional data, more frequent trades, and more in-depth analysis won't save us from self-defeating acts. Contrarily, excessive information can widen the gap if it causes hyperactivity and overconfidence. With the ability to easily access our account balances, follow the herd, and fear scroll the news, we’re more vulnerable than ever to the biases that hurt our pocketbooks.

Richard Thaler, a Nobel Prize Laureate, specializes in studying human behavior in the context of economic decision-making. Through his research, he has analyzed how social preferences, emotions, and other traits can influence seemingly illogical choices. In his study of "myopic loss aversion," he found that investors who reviewed their portfolios more regularly tended to select overly conservative investments, regardless of objectives or time horizon. At first glance, this sounds positive. It may seem as though these watchful investors are simply employing thoughtful investment strategies. But, in reality, they missed out on gains that might've been crucial to meeting their objectives. 

Thaler also pointed out that attempting to time the market can cause investors to miss out on significant market upswings. Now armed with data and "evidence," lay investors are more tempted to try and time the market. In his book, Thaler pointed out that when students are surveyed, only 5% place themselves in the bottom 50% of the class. What does that mean? It means we are often overconfident, and our (unfounded) bias can grow even more detrimental with more information available. 

We tend to believe that having access to information gives us an edge. Data gives us a sense of control that we crave. Like the professional handicappers in Slovic’s study, our confidence rises when we’re armed with information, even when that information doesn’t generate success. If we desire long-term success, we must acknowledge the behavior gap, stay mindful of our biases, and separate our emotions from the results. Sometimes, a dose of simplicity is needed to cure a case of information overload.