Three delusions that lead even the most knowledgeable investors astray

The recent upward revision of the UK’s economic output during Covid was surprising for a couple of reasons.

First, the Office for National Statistics’ updated GDP figures changed the narrative about Britain’s performance during the pandemic. It turns out we were not the economic weakling we’d been led to believe.

Perhaps more importantly, it suggested that the data that informs our policy and investment decisions is a lot less reliable than we might hope. For the country to be £50bn richer at the click of a mouse is not nothing.

There’s been some wringing of hands and calls for an investigation into what our statisticians think they’re up to.

I draw a different conclusion. As investors, we should accept the limitations of what we know and think we can control. We should focus less on the backward-looking minutiae of economic statistics and more on the general direction of travel.

For one thing, that could free up a lot of time to do some real thinking, which in the long run will serve us better than poring over flaky data.

It’s hard to measure the link between the “sick man of Europe” narrative and the underperformance of the UK stock market.

But there must be some connection between our low sense of economic self-worth and the miserable valuation multiple that’s applied to British shares. It’s hard to imagine that the outlook for British companies is only half as good as for their US counterparts. But that is what the market is telling us.

Sentiment aside, there are at least three other reasons why investors’ hyper-focus on economic data is unhelpful.

The first of these is the illusion of knowledge, the misguided belief that more information is better information. A classic behavioural study from the 1970s showed this to be a myth.

The study took a group of experienced bookmakers and gave them a large amount of widely used data on racehorses which they were asked to rank in importance. They were then told to predict the first five horses in a sequence of races using, first, the top-five-ranked pieces of data, then 10, 20 and finally 40.

The conclusion of the study was that the accuracy of the predictions remained almost unchanged the more information they had. But the confidence in the forecasts doubled as the study’s participants were given more data. Bookies, like investors, think that the more they know the better they can do their job. It’s probably not true.

Bookies, like investors, think that the more they know the better they can do their job – which isn’t necessarily true Credit: John Walton/PA

A second illusion investors suffer from is one of control. Even if we are not King Canute, it is human nature to think that we have agency over uncontrollable events.

For example, people are more likely to accept a bet on the toss of a coin before it has been flipped rather than afterwards when the outcome has been hidden. It’s as if we think we can influence the coin while it’s in the air.

Intellectual vanity means professionals are particularly prone to this bias.

Asked to decide which of two shares would outperform on the basis of a set of facts, including past performance, a group of investment professionals did as badly as a group of lay people. However, they arrived via a different route. The lay people looked at the recent performance and were happy to admit they had guessed. The professionals naturally denied sticking a finger in the air and pretended to rely on “other knowledge”.

A third intellectual flaw when it comes to data is the illusion of relevance.

A good reason to not worry too much about the ONS’s GDP revision is that it is probably immaterial when it comes to the performance of the UK stock market. We know that UK shares are influenced more by global factors and that stock markets anyway march to a different beat than the economy. But that does not stop us anchoring our decisions on the irrelevant.

Sometimes our ability to delude ourselves is laughable, as when a group of people was asked the proportion of UN countries that were in Africa. They gave their answer shortly after being shown the spin of a rigged wheel of fortune with numbers from 1 to 100 but which only ever showed either 10 or 65.

The average percentage guessed by those who saw 10 was 25pc; those that were shown 65 guessed 45pc on average. Faced with a question they didn’t have a clue about, they simply clutched at an irrelevant number. The answer by the way is about 20pc.

None of this would matter much if it didn’t have the potential to push us into expensive mistakes.

I remember 20 years or so ago working with a technical analyst who, close to the bottom of the bear market that followed the bursting of the dot-com bubble, declared that the world was going to hell in a handcart and that he was selling his house in Fulham. He didn’t quite say he was stocking up on baked beans and Kalashnikovs and moving to a cave in Idaho, but you get the picture.

In a panic after three years of falling share prices, he had hyper-focused on a bunch of irrelevant data, was caught up in a horrible illusion of knowledge and thought that his charting prowess could somehow influence the fate of the London property market.

Fortunately, his wife told him not to be so silly, and as far as I know he is still in Fulham in a house worth many times what he could have sold it for in 2003.

What my friend would have been better doing was thinking. It was tempting after months of falling markets to conclude that the end of the world was nigh. But, in reality, investors had simply stood under a cold shower after a bout of irrational exuberance in the late 1990s internet boom.

As for house prices in Fulham, well funnily enough, London did not turn into a dystopian hellscape and far more people still want to live in its nicer bits than there are houses to accommodate them.

Wrong statistics may well be dangerous for policymakers. At least as investors we can take them with a pinch of salt.

Tom Stevenson is an investment director at Fidelity International. The views are his own