FOR RELEASE: May 21, 1998
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ITHACA, N.Y. -- What you don't know may not kill you, but it can certainly cost you money, especially when you think you know more about investing than you do. Contrary to widely accepted efficient markets theory, less-informed investors consistently tend to "buy high and sell low," systematically transferring their wealth to better-informed traders through overly aggressive trading, according to a ground-breaking study of investor confidence and knowledge by professors Robert Bloomfield, Robert Libby and Mark Nelson of the Johnson Graduate School of Management at Cornell University.
"In our laboratory experiments, we created 'less informed' investors by giving them small amounts of information about a company and compared their confidence and trading decisions to another set of more-informed subjects who were given more data," Bloomfield said. "Ideally, the less-informed investors should be less confident about their predictions of security value, and trade more cautiously. But we find they are every bit as confident as those who really do know more. When they have a little good news, they act as if they have a lot. So they buy aggressively from more-informed investors, driving prices up too high, and losing money as a result."
The experiment shows that it isn't simply a lack of information that can hurt less-informed investors. Rather, it is their tendency to overestimate the quality of their information. "More-informed investors are better off because they get information from so many sources," Bloomfield observed. "Serious investors get lots of good news and bad news. All of these conflicting signals lead them to be a little more careful in drawing conclusions. But casual investors often rely on just a few pieces of information, such as an earnings report or a personal experience with a company. If all they see is one piece of good news, they are much more likely to think the stock is a sure winner."
These findings, Bloomfield observed, undercut regulatory proposals to permit the disclosure of corporate financial information in limited, summary formats aimed at those without the time or inclination to study the detailed financial reports now required of publicly traded firms. Both the SEC and the FASB (Financial Accounting Standards Board) have recently considered and rejected proposals that would permit firms to exclude important footnote disclosures.
"The assumption behind these proposals is that summary financial information spares casual investors of the need to plow through detailed reports, while giving them the basic information they need to invest in an efficient market, where the prices reflect all available information," Bloomfield said. "Our evidence suggests that this assumption is wrong. Prices in our markets aren't efficient, because the less-informed investors bid prices up too high. Summary reports will only strengthen the illusion of less-informed investors that they are masters of their fiscal domain. Their overconfidence conceals their ignorance from them and prompts them to make even worse decisions. For the casual investor, the detailed financial statement, with its extensive tables and obscure footnotes, is a 'Caution' sign -- a vivid reminder of what they do not know."
In the two sets of experiments that are reported in this paper ("Confidence and the Welfare of Less-Informed Investors"), the investors were portrayed by MBA candidates at Cornell's Johnson Graduate School of Management. "As casual investors go," Bloomfield noted, "our subjects were more sophisticated than the average stockholder. I would guess that most small investors would be even more susceptible to the types of errors we observed."
Bloomfield also pointed out that overconfidence can hurt small investors in other ways not examined in the studies. "We showed only that the less-informed investors would buy high and sell low. But overconfidence will also lead investors to buy and sell too often, and to buy the wrong types of stocks. High transaction costs and poorly balanced portfolios will only compound these poor returns."
Bloomfield, associate professor of accounting at Cornell's Johnson School of Management, is one of the country's leading researchers in the controversial field of 'laboratory markets.' Laboratory market research uses a combination of economic theory and psychology to predict market behavior and then tests these predictions by having people trade securities in a highly controlled laboratory setting.
"Laboratory markets are going to remain controversial for a while, because so many researchers in economics and finance are unwilling to accept that investors are often irrational," Bloomfield said. "My goal has been to show how adding a little bit of realistic irrationality can change our prediction of how markets will behave. This, in turn, changes our recommendations about regulatory policies. Most researchers in finance and accounting think there is no reason to protect small investors, because they will protect themselves. Our experiments suggest that this is wishful thinking.
"Cornell is a great place to do this type of inter-disciplinary research," said Bloomfield. "It is one of the few places in the country where researchers in finance, accounting and economics meet regularly with psychologists and sociologists and actually communicate."