The more you know about an investment, the better your judgement should be, surely. But it’s not quite that simpleby Andy Davis / March 23, 2011 / Leave a comment
A colourful narrative is easy to back: India’s rise to economic stardom is a story that sells
As an investor, you necessarily accept that you must put your money at risk in pursuit of reward. The natural way to navigate this trade-off is research. The acronym commonly used is DYOR: Do Your Own Research, which by no coincidence is similar to DIY. It’s a worthwhile sentiment. But how much research is the right amount?
For many people, the answer is “a lot.” Some, particularly the retired and semi-retired men who make up the hardcore of DIY investors, have the time to put the work in and enjoy it. Others, who want to run their own investments but are short of time, feel that research offers the best way to gain confidence in their decision making and avoid losing money. But whether your time is your own or shared out among other commitments, how do you know when you’re ready to go ahead with the deal?
If you’re looking at the shares of a single company, you’ll find thousands of pieces of financial information freely available on its website. Armed with a calculator and a few formulae, you can crunch these numbers and work out lots more ratios that might just hold the key—enterprise value to earnings before interest, tax, depreciation and amortisation, earnings yield, take your pick. It’s a feast of jargon. But most professional investors will agree that the information in a company’s published accounts still provides an imperfect picture of what’s going on inside the business. And what about an investment fund? If understanding the finances of one company is tricky, try picking apart the portfolio of assets held in a fund to work out its prospects.
What’s the average person to make of this? Help is at hand—from James Montier, a leading writer on behavioural finance (essentially the study of how humans—bundles of emotion blended with occasional rationality—go about making investment decisions). Montier reports a fascinating experiment in which the subjects were given an increasing quantity of information on which to base judgments. Although their confidence in their decisions increased steadily as the quantity of information at their disposal increased (from five pieces, to ten, to 20 and finally 40), their accuracy did not improve at all. Amassing ever more information will not necessarily help you make better decisions.
What humans love and understand, as Montier argues,…