Saturday, January 14, 2006

Is too much knowledge a good thing? 3 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
The three key words that define the issue above is "paralysis by analysis". Can one over-analyse and consequently submerge himself and his stock portfolio through an avalanche of data and information? It is entirely possible.

One important difference here to note, of course, is information versus knowledge. Information is unprocessed data and newsbites, readily available especially over the Internet nowadays; however knowledge is harder to define: it is more an amalgamation of such information to form coherent contextual views about industry dynamics and company dynamics. Information is useless, and indeed, may be harmful, if one chooses to be a sponge and keep absorbing information while not processing it mentally. The danger is twofold: loss of focus, an element as important as anything else in stock investing; and secondly an inability to recollect old information because new information keeps streaming in (in accounting terms, known as FIFO: first in first out).

Under the Random Walk hypothesis, the market price is reflective of all fundamental information that is available on a company, publicly or otherwise. This of course has led to the cliched dart-throwers-beat-fund-managers anecdote (whether true or not) and indeed if we take it to the extreme it suggests there is no point to keep up with the news since stocks are already efficiently priced (although if everybody believes in this and does not keep up with news updates, clearly the market can't be efficiently priced!). Indeed, to the extent that more information (or even knowledge) tends to reduce one's risk appetite, it does suggest that more knowledge means reduced portfolio performance, due to the general direct retationship between risk and reward (provided one has the discipline to skim off profits at the upswing for the volatile stocks).

From personal experience, my best performer so far in my market life so far, if the gain is annualised (ie. time is taken into account), has been in a stock called Allied Technologies, a precision stamping firm that IPOed in mid-2003. I bought the stock in July 2003 at the price of 27 cents given its low PE of 7-8 times and a generally strong precision stamping business with blue-chip customers like HP. Today, if you ask me I wouldn't venture into IPO stocks because they typically manage earnings to peak at the IPO year to obtain optimal valuations. Indeed, the company's earnings have declined ever since; today it is thinly traded, at about 11 cents. BUT I was rewarded for taking such a risk (although I wasn't entirely cognizant of IPO-related risk in mid-2003) for Allied surged to >70 cents in October 2003 on (retrospectively ridiculous) market reports that it could double or triple revenues and profits on its new LCD assembly plant. I cashed out at 65 cents for a 2.5 bagger within 3 months, or 10 times if annualised. So much for a fluke being my best performer; one may also interpret it that less knowledge somehow confers on the small investor a higher risk-taking appetite that may be beneficial in a bull market.

In fact, I would put it this way: if one takes the view that price rises are composed of a fundamental (systematic) component and behavioural /psychological/ emotional (random) component, a more knowledgeable investor/trader tends to have an advantage in the systematic fundamental component as he is clued in to more industry news and can analyse them better; however his risk appetite tends to be attenuated and he prefers not to go into the more "dangerous" stocks where the random, and often highly volatile, component can indeed cause prices to surge without any rhyme or reason. So more knowledge tends to lead to a better performance in the systematic component but poorer performance in the random component, leading to probably a flatter and less volatile portfolio performance. Over the long term the more knowledgeable investor will probably outperform the less knowledgeable investor given he has a sustainable advantage in the systematic component. However, indeed, if one has holding power and adopts a strategy of disciplined profit-taking he might be better off with less knowledge and a higher risk appetite if he chooses more volatile stocks and takes profits strictly without letting price momentum affect his strategy. The price moves faster and stronger for such stocks.




Anonymous Anonymous said...

Random walk types tend to be academics.

With experience come the realization that assets can remain inaccurately priced for considerable periods.

Psychology is more important than valuation models in the short term.

1/15/2006 12:26 AM  
Blogger DanielXX said...

I tend to think that the market responds efficiently to breaking news or even news about to go public; however it is slow to respond to fundamental industry trends and may not price this aspect in efficiently.

As a matter of fact I have written something on this. The link is below:

1/17/2006 7:13 AM  

Its easy to become overcome with all the information available about investing.

12/11/2012 4:21 PM  

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