Some time back, a psychologist named Slavic decided to find out the accuracy of the predictions made by handicap pickers on horse races. He put together the relevant pieces of information about every horse and other factors and then tested it on the experts.

In the first race, he gave them five pieces of information. In the second he gave 10 pieces of information and then increased it to 20 pieces and finally to 40 pieces of information by the fourth race. Based on the information made available, he asked the experts to pick the winners of the race and also the level of confidence in that forecast.

Since there were about 10 horses in each race, the random chance of winning forecast was about 10%. A random choice has the same level of confidence for each of the forecasts. The experts, armed with some additional information, were able to eke out a 17% hit rate for winners and their confidence in their forecasts ranged between 15-20%. This was not bad because the hit rate improved by 70% over random.

By the time of the fourth race (by when the experts were getting more and more information), Slavic found that the hit rate of the experts continued to be around 17-18% but the confidence level had moved to between 35-40%. This is an interesting finding.

How this translates into trading is that when you have more information, you end up taking a larger position in the trade. Since your accuracy is not really improved by information, the larger position has actually induced a much greater level of risk!

Let me illustrate this with some personal history.

Way back, when I was a newbie in the market, I bought Great Eastern Shipping Ltd. on the advice of a market analyst. Back in the late 1970s and early 1980s, detailed fundamental research was almost non-existent. Along comes this gent from London, Marfatia was his name, and he gives me, lo and behold, a write-up on GE Shipping with “a case for investment”! Floored, I decided to buy. I had a personal meeting with the guy and he waxed eloquent about OBO carriers and Baltic Freight Index and the big fleet that GE Shipping had etc. Maybe he also threw in replacement cost theory – only Harshad Mehta had not come around till then!

I was still in college but had started actively dabbling in stocks by that time. But I got so convinced with all the information that the analyst gave me (A Case for Investment, Gosh!) that I decided to bet it all on this one. I bought 3,000 shares at Rs 67.00 and it soared soon to Rs 72.50 and I was delirious! From there the stock started to tumble. No problem, I told myself, this baby is going to soar, that’s what Marfatia had assured me. And he was an FCA from Wales! Secure with that knowledge, I held on.

It came to Rs 36 and my confidence was deflated. So I did the only thing possible – went back to confront Marfatia, when in fact I should simply have sold. He pulled out more data and figures and he got my hopes up, saying “tamara bhav aavi jaashe” (your price will come). Now, that’s all I wanted to hear. What’s more, I was now armed with new information about GE Shipping. Can’t lose, is how I felt.

(Photograph: GE Shipping website)

(Photograph: GE Shipping website)

Cut a long story short here. The stock kept declining and went all the way down to 10 bucks. That was it. I couldn’t bear it anymore. I dumped it at Rs 9.75, having blown away a whole lot of money. This was 1978-79, remember, in which time I sold family holdings in Hindustan Lever Ltd., Kinetic Engineering Ltd., Colgate Ltd., etc to fund this disaster.

I have good trader instincts (or at least I like to think so) and bereft of that ‘information’, I may have bailed out much earlier. Marfatia is not to be blamed. I was. For trusting information that created a false sense of security within me and almost took me to the cleaners.

Understanding this is a very important aspect of trading. What you really need is not something that gives you more information but a method that improves your accuracy of the forecast. When that improves, and you increase your bet size, then you end up winning big!

When we have more information, we tend to slip into confirmation bias. We look and accept information from the environment that is favourable, as against information that conflicts. This is how we end up ignoring important information and get lulled into a belief that may work against us. This often leads to bad investment decisions.

So, what’s the solution?

Here is another story from the past, a little over a decade after that first incident, in 1991-92. I was now a sub-broker on the floor of the trading ring, part of the big melee that many of you would have seen in ‘Scam 1992’. We got news about an impending bonus issue in Southern Petrochemical Industries Corporation Ltd. or SPIC and it was around Rs 100. Everyone in our office bought a bundle. Then Harshad Mehta got into the stock and it skyrocketed to Rs 160. We were are jumping with joy, for, the King was going to take it to the moon! But something went wrong. Prices started slipping. The bonus came through (1:1) and it still slipped some more. Around Rs 130, I met another sub-broker friend who said that he had just spoken to Harshad’s guys and they told him that it would go to Rs 180 in the following week. Those were the times that such talk would really work!

Cut to the chase. A week later, the stock was slipping again after a brief rally. It hit Rs 128 and I dumped my whole bundle. There was plenty of news around that was all hugely encouraging. Harshad was still holding and his circles were talking in positive tones. We found out much, much later that Manubhai was walloping the stock to squeeze Harshad. But that wasn’t available information back then. I just used my training in technical analysis to bail out early enough. Eventually, SPIC fell to Rs 30. And kept sliding, all the way till 2003!

It is very difficult to go against the prevailing news and sentiment. At our core, we like to be sure of what we are doing. And for doing that we seek more information, out of the belief that more is good. I had learned one very, very expensive lesson ten years before this incident and had decided that I would not be influenced by extra information. Bonus issue, who is buying, who is holding, what are prospects for the next N quarters etc. etc. are all information points that are okay to seek and have, up to a certain stage. If the price doesn’t behave and stay in line, then that’s it. The market, in the end, is supreme.

I have faced this dilemma for many years and finally solved it by designing my own information screening software. It is called Neotrader, and is designed to increase your accuracy by weeding out the noise in the market and helping you focus on the stocks that have a high probability of succeeding.

With so many possibilities thrown up at any point in time, chances are that analysis will tilt us towards confirmation bias and we will end up wrongly weighting the factors.

What we really need to do is to put together the information in a way that enables us to focus on a few important elements. There are various screeners available on the internet for putting together data on the fundamental as well as the technical side. Neotrader has the facilities to do both.

So, taking some learning from the Slavic experiment, let’s concentrate on information that can increase the probabilities of our forecast coming right rather than just falsely increase our own confidence in a forecast.

CK Narayan is an expert in technical analysis; founder of Growth Avenues, Chartadvise and NeoTrader; and chief investment officer of Plus Delta Portfolios.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.

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