Introduction to Critical Thinking and how top investors use it.
Marketwatch published a guest comment yesterday that I thought was a good introduction to the concept of using critical thinking skills to counteract the natural biases and misperceptions we bring to our investment decision-making. It focuses on what I’ve been calling the Fog of Information in previous posts, and points out that there is a limit to how much information we humans can process before it begins to lose value. Information Overload is another term we commonly hear to describe this phenomena. The question is, what can we do to improve the process of sifting, sorting, and filtering the massive flow of data and opinion that streams at us all day, every day? Here are some excerpts from the article.
The price of paying attention, By Kent Thune.
“A wealth of information creates a poverty of attention and a need to allocate that attention efficiently among the overabundance of information sources that might consume it.” ~ Herbert Simon
How much information can you consume and how does it impact your potential to make prudent investment decisions? To be informed, you must consume information. But what is it that information consumes? It consumes your attention, which may be the most overlooked, undervalued asset in the investor community.
Herbert Simon described bounded rationality, which says that the rationality of individuals is limited by the information they have, the time available to make a decision, and the finite cognitive capabilities of their minds. His solution for overcoming bounded rationality is to consciously allocate the attention.
But how does one go about allocating their attention? Should investors give as much care in constructing a portfolio of information as they do in building a portfolio of investments? Is there a direct correlation between information consumption and investment returns?
Barry Ritholtz, author of The Big Picture blog, says “Investors have this cognitive bias that ‘more information’ helps them make better informed decisions. It turns out not to be true; more information helps them be more emotionally comfortable with their decision making — overconfident in fact. Paradoxically, more information leads to overconfidence and worse decision making.”
“Faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.” ~ John Kenneth Galbraith
Another trait that can make the investor his or her own worst enemy is confirmation bias, which is the tendency to find information that agrees with one’s existing view; information that reinforces favored preconceptions is over-weighted (also known as self-attribution bias); and any information that conflicts with this view is ignored.
Investors need to have a heightened awareness of their information diet, where junk in/junk out certainly applies. Perhaps no one knows this better than Tadas Viskanta, author of Abnormal Returns, a blog that has built a large audience of readers by providing a steady stream of low-hype, high-quality information for investors.
How to improve ROI (Return on Information)
Ritholtz, who says “we switched off the TVs in the office about five years ago and never looked back,” suggests investors and traders can improve their information allocation, and thus their potential for higher investment returns, by first eliminating the “bad, unreliable or biased sources” and to be reflective and introspective:
“Why are you consuming content? Are you looking to confirm a previously held belief? Are you looking for additional information to make you feel good about your decisions?” He also urges, “Have a methodology that is not dependent upon finding some tiny piece of hidden info. That is not a repeatable process.”
Viskanta adds that “traders and investors need to be proactive in their approach to media consumption” and cautions, “We all have to recognize that the financial media is a business and their business is generating viewership and page views.”