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When knowledge is a dangerous thing

More informed investors do not necessarily make better decisions.
July 30, 2020

More knowledge can sometimes be dangerous for investors, according to new research.

“People with high financial literacy tend to take too many risks,” concludes Kansai University’s Taizo Motonishi in a new paper. He shows that more knowledgeable investors are more likely to borrow too much, to buy speculative stocks and to invest in expensive funds.

One reason for this is that it can lead to overconfidence and to what the Nobel laureate Daniel Kahneman calls “the illusion of knowledge”. Earlier research by Martin Weber and Sebastian Muller has found that sophisticated investors buy expensive, but poorly performing unit trusts because they over-estimate their ability to pick good funds. As Charlie Munger said, “it’s the strong swimmers who drown.”

Also, says Professor Motonishi, financial literacy doesn’t protect us from fraudsters simply because knowledge of financial products is not the same as wisdom or judgment of character. As Dan Davies showed in his brilliant book Lying for Money, clever people fall victim to conmen as well as mugs.

Another reason is simply that the future is to a large extent unknowable no matter how clever you are, which means there are limits to how much any amount of knowledge can help us. In other recent research, Catherine D’Hondt at the University of Leiden shows that financially literate investors are no more likely to meet their targeted returns than others, because knowledge raises expectations more than it raises the ability to meet them.

In a sense, though, we don’t need academic research to tell us all this. History teaches us the same thing. Long-Term Capital Management collapsed in 1998 despite being run by some of the best financial minds in the world. And 10 years later, banks collapsed despite being run by clever people (or, perhaps, because they were so run). Granted, this might have been because clever people had incentives to be stupid – to follow the herd and to downplay risk. But the point holds – that brains alone don’t stop us making bad decisions. More prosaically, but more pervasively, actively managed funds under-perform the market despite being run by very knowledgeable people.

We must not, however, be too contrarian here. We also have good evidence that financial knowledge can sometimes help us.

Some of this comes from a study of French investors in assurance vie products, which allow people to switch between equities and bonds within a tax shelter. Milo Bianchi at Toulouse School of Economics shows that better-informed investors earn higher returns on these, in part because they are more likely to rebalance towards equities when prices are low and expected returns higher and less likely to sell when prices are low. Granted, the advantage is small – less than half a percentage point per year – but this is because returns are largely unpredictable however clever you are. But even a small advantage compounds nicely over an investing lifetime.

What’s more, work by Professor D’Hondt and colleagues shows that financially literate investors do some smart things. They are slightly more likely to run their winners and cut their losers than less knowledgeable investors, and so less likely to expose themselves to the wrong sort of momentum. They are also less likely to buy shares they know nothing about. These habits do enable them to perform better. But the payoffs to them, while statistically significant, are small – smaller than the advantages of being older, wealthier, better educated or the right gender.

Yes, gender. Professor D’Hondt finds that women make better investors than men, a finding corroborated in the UK by Neil Stewart at Warwick Business School. This is partly because women are less prone to overconfidence than men, but also because they are less likely to buy lottery-type stocks which tend to do badly.

If you want to be a successful investor, it’s probably better to be a woman than to be well-informed (though of course you can be both!).

Perhaps, though, all this isn’t as surprising as it seems. Financial literacy is not enough. We also need psychological literacy. Many of the mistakes we make in investing arise not from ignorance of financial products but from an ignorance of the mind. Overconfidence, an excessive readiness to trust people who seem credible and a tendency to be overly influenced by peer pressure are all mistakes we make outside of investing. And we make them in investing even if we know a lot about finance. The biggest thing we must know is the circle of our competence.