Our information-based society is often plagued with excess. There are many areas of everyday life in which information overload prevails, but the investment sector may well be where the consequences are the most serious. And the less financial knowledge and understanding people have, the worse they cope.
Information Overload Leads to Bad Decisions and Passivity
An important investigation on this very issue by Julie Agnew and Lisa Szykman (both professors at the Mason School of Business, Williamsburg, VA), published in the Journal of Behavioral Finance (2004), reveals that people with a low level of financial knowledge suffer particularly from overload, which leads them to take the path of least resistance, the "default option" in defined contribution retirement plans. Many are simply overwhelmed and cannot cope at all. (For a related reading, see Taking A Chance On Behavioral Finance.)
TUTORIAL: Behavioral Finance
Use Investment Information Effectively
For a lot of people, financial security and peace of mind depend on making the right financial decisions now and in the future. Yet, there is growing evidence that far too many individuals make very poor decisions, and many cannot be described as making decisions at all.
While some investors inevitably have too little information, others have too much, which leads to panic and either bad decisions or trusting the wrong people. When people are exposed to too much information, they tend to withdraw from the decision-making process and reduce their efforts. (A lack of information, which one could call "underload" can have the same result, by the way, and is certainly just as dangerous).
In other words, simply providing people with information about investment options, may not be enough to produce rational and sound decisions. Investment information needs not only to be sufficient without being overwhelming, it also needs to be easy to use, and actually be used. This is a very real problem with potentially dreadful consequences. (To learn more, see Financial Media 4-1-1 For Investors.)
The Specific Causes of Overload
Agnew and Szykman tell us that there are three main causes of information overload. One is pure quantity. The second is having too many options (although too few is also bad), and the third factor is option similarity. If everything seems the same, differentiating one alternative from another is confusing and difficult. We'll use their findings to extend to general investors rather than simply DC plan contributors.
Also important in the use of information is the investor's level of financial knowledge. That is, knowledge which is directly relevant to the investment process. Theoretical economic or general business knowledge may be no help at all, being too removed from the nuts and bolts of money management. We are talking here about an awareness of how investment should be done in practice, what works and what does not.
The research indicates that many investors don't even have a basic understanding of financial concepts. This applies more to those who earn less. Not surprisingly, people who have never had much money, have had little practice in investing it. For this reason, someone who suddenly wins the lottery or inherits is often at a loss, initially metaphorically and then, not uncommonly, literally. (For a related reading, see Do Financial Decisions Get Better With Age?)
Consequences of Overload: Asset Misallocation
Floundering in a maze of information opens people up to misselling. Namely, getting really lousy, unsuitable investments foisted on them. These may be too risky, too conservative or insufficiently undiversified, to name just three of the classic horrors. In short, investors land up with investments that are lucrative only for the seller, or which are simply easy to sell and no trouble to manage.
In their experiment, Agnew and Szykman found that people who were not coping with the investment information just went for the "default option," which was easiest to do. They did not bother to find out what is really best for them. In the real world of investment, this is truly dangerous. An investment that is totally devoid of risk, just cash, for instance, really does not pay off in the long run. This option may lead to an inadequate retirement fund, and almost everyone should have some equities.
By contrast, having too many stocks or weird, exotic funds, assets and certificates, is extremely volatile and can win or lose you a fortune. Most investors do not want such risks, and are often unaware that they are taking them – until disaster strikes. This kind of portfolio can lead to wealth, if you are lucky, and poverty if you are not. For most people, it is not worth the gamble, neither psychologically nor financially. (To learn more, see Achieving Optimal Asset Allocation.)
Coping with Information Overload
This can be done from both sides of the market. Brokers, banks and so on, need to ensure that they only provide investors with what they really need to know, and it must be simple to understand. The point is that the average investor needs to be informed sufficiently (but no more) on what will help them make the right decisions. There is a clear optimum, beyond which dysfunctional overload occurs, and of course, too little is just as bad. It is also absolutely essential for the sell side to ensure that the information is understood and converted into the appropriate investment decisions.
If investors themselves find they are being swamped with information, and truly do not have the skills or time to figure it out and use it, they need to go back to the seller and ask for concise information that they can use. If this fails to be provided, it is probably best to take one's money and business elsewhere.
Investors themselves do need to make an effort to find out what is appropriate for them. As indicated above, this can be daunting, but for this reason, sellers and regulators need to get the message across that the more they learn and the more they know, the safer the investment process.
There are inevitably some people who just cannot or will not understand the information and use it. This may be due to a lack of education or a phobia about money, and some people are just not prepared to bother with their money. Such individuals do then need some sort of independent advisor whom they can trust. (For more, see Advice For Finding The Best Advisor.)
An important research project from the Mason School of Business in Virginia informs us of the very serious problem of information overload (or the converse of "underload") in the financial services industry. Ensuring that investors have an optimal amount of information that they can (and do) understand, and really use as a basis for decision making, is easier said than done. But it must be done; both the industry and investors themselves need to be proactive in solving the problem. The variety of potential investments, and the evolving nature of the relevant markets means that an ongoing, reciprocal and productive process of information provision and utilization is absolutely fundamental to people's financial future and peace of mind.
Investing BasicsIn specie describes the distribution of an asset in its physical form instead of cash.
EconomicsCross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
Investing BasicsWhen stocks rise or fall, the financial fate of investors change, as well. There are certain signs that can reveal a stock’s course, and investors don’t need to be experts to spot them.
Investing BasicsA look at two different trading strategies for ETFs - one for investors and the other for active traders.
Fundamental AnalysisWith a backdrop of armed rebels and drug cartels, the journey for the Colombian economy has been anything but easy.
Investing NewsAn addiction to trading can ruin your life and relationships. Not to mention the monetary costs. There are telltale signs that you've gone too far.
Fundamental AnalysisChile has become one of the great economic success stories of Latin America.
InvestingWhile recent market volatility is leading investors to look for the nearest exit, here are some suggestions for bond exposure in attractive sectors.
EconomicsThe movement of money for investing, trade or business production, is commonly referred to as capital flows.
InvestingBeing in the stock market for so long I tend to look at the world through the eyes of a trader, but how to decide when we are presented with two options?
Mutual funds split in the same way that individual stocks split, but less often. Like a stock split, mutual fund splits do ... Read Full Answer >>
In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
In statistics, regression analysis is a widely used technique to uncover relationships among variables and determine whether ... Read Full Answer >>
The modified duration gauges the sensitivity of the fixed income securities to changes in interest rates. To calculate the ... Read Full Answer >>
In finance, the rule of 72 is a useful shortcut to assess how long it takes an investment to double given its annual growth ... Read Full Answer >>
In statistics, the standard error is the standard deviation of the sampling statistical measure, usually the sample mean. ... Read Full Answer >>