Markets And The Horse Race Handicap
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 items 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 progressively 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.
What it meant was that with more information, people feel much more confident about their forecasts even though their accuracy of the forecast has not changed much!
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!
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 go towards confirmation bias. We look and accept information from the environment that is favourable compared to conflicting information. This is how we end up ignoring important information and get into a belief that can work against us. This often leads to bad investment decisions.
So, what’s the solution?
Handle the right kind of information in the right quantity.
I have faced this dilemma for many years and finally solved it by designing my own information screening software Neotrader. It 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.
When you look at balance sheets, most people don’t even know where to begin and how deep to go. Similar is the case with charts. 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 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 Net 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.