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OPINION

When ignorance is bliss

When ignorance is bliss
August 13, 2015
When ignorance is bliss

As he shows in a new paper, such deliberate avoidance of information is common. Political partisans don't want to hear their opponents' strongest arguments; men are loath to visit the doctor if they fear they will receive bad news; and some bosses don't want to hear arguments against their strategy, even if these might help them implement it better.

This raises the question: is such wilful ignorance rational or not?

Common sense says it can't be. If we are to take the best decisions, we need all available information. Of course, a lot of that information will be irrelevant - it will be noise, not signal - but this is a case for ignoring it once we have it, and not for not getting it in the first place. Hard evidence supports this common sense. Economists at Goethe University in Frankfurt have shown that investors who get regular feedback on their portfolios earn higher risk-adjusted returns than ones who do not.

However, things aren't quite so simple. As the Nobel laureate Thomas Schelling pointed out in a famous paper in 1956, ignorance can be power. For example, the man who doesn't know the costs of a break-down in negotiations will adopt a tougher negotiating stance and so extract concessions from the better-informed side. And bosses might prefer to be ignorant about the misbehaviour of their employees to avoid legal liability.

Ignorance can also help investors. One reason for this is that a lot of what appears to be information is in fact mere noise with no predictive power for returns. Although in theory we could discard this, in practice it is hard to distinguish between the two. As Harvard economists Brock Mendel and Andrei Schleifer have shown, even quite rational investors can sometimes trade on noise and buy overpriced assets. The wilfully ignorant investor avoids this danger.

Also, ignorance can be a commitment device, helping us to stick with good strategies during bad times.

One way in which it does so is by helping us to overcome what Richard Thaler and Shlomo Benartzi have called "myopic loss aversion" - our tendency to hate short-term losses more than we like equally-sized gains.

Imagine - for the sake of concreteness - that equities offer a real return of 5 per cent a year with a normally distributed standard deviation of 20 per cent. If you look at the market every day, you'll see almost a 50:50 chance of a drop. But if you look only once a year, you'll see a less than one-in-four chance of a loss. And over 10 years there's only around a one-in-six chance of losing money. For someone wanting to avoid losses, therefore, equities look like a bad investment if you look at them every day, but become more attractive if you look less frequently.

One way to steel yourself to invest in equities, therefore, is to pay little attention to day-to-day market gyrations.

Similarly, if you invest in 'unethical' stocks, a blindness to their alleged wrongdoings can help you to stick with them and so profit from their tendency to outperform over the long run. Mutual's Barrier fund (previously known as the Vice fund) has comfortably beaten the S&P 500 since its launch in 2002, tripling in price while the index has risen 137 per cent. This is no accident. To the extent that some investors avoid 'unethical' stocks, these will be underpriced and so offer good returns to the investor with fewer qualms.

Wilful ignorance might have another virtue. There's a danger that as our knowledge increases, our confidence increases even more, creating what the Nobel laureate Daniel Kahneman has called the "illusion of skill". This can cause us to trade too much, to take excessive risk and to buy high-charging but mediocre funds in the mistaken belief that we have the ability to spot good fund managers. The less informed investor avoids these pitfalls of overconfidence.

All this seems paradoxical. How can we reconcile the common sense idea that more information is a good thing with the fact that, sometimes, wilful ignorance is a good thing?

Here's a theory. Remember the theory of the second best, proposed by Kelvin Lancaster and Richard Lipsey back in 1956? They proved that where there is some kind of market imperfection, welfare can be increased by introducing another imperfection. For example, price controls - which are usually a bad idea - can be efficient as a means of combating monopoly power. A similar thing is true for rationality. If there is an imperfection that prevents us being fully rational, another imperfection can push us closer to a good decision. So, for example, if we would misinterpret information - say, by becoming overconfident because we have it - it might be better for us to avoid that information. Being fully informed would be a good thing if we were rational, but it isn't necessarily so if we are not.

In this sense, the important distinction isn't between being ignorant and informed but rather Isaiah Berlin's distinction between the fox and the hedgehog: the fox knows lots of little things, while the hedgehog knows one big thing. What matters, perhaps, is not that we know lots of little things but one big thing - that we are prone to countless errors of judgment.