The internet is making you a worse investor

Levels of financial literacy have been dismally low for years, of course, so this need is hardly new. Yet our collective financial literacy appears to be facing a new and very modern threat: The internet.

According to research posted this summer on the Social Science Research Network (SSRN), the internet leads investors to think they know more than they really do, and the resulting overconfidence in turn causes their portfolios to perform less well. I first heard about this fascinating research from the always-insightful Joachim Klement, a trustee of the CFA Institute Research Foundation and former head of equity strategy for UBS Wealth Management.

The SSRN study, entitled “Confidence Without Competence: Online Financial Search and Consumer Financial Decision-Making,” was conducted by Adrian Ward, a marketing professor at the University of Texas at Austin; Tito Grillo, a professor of marketing, business economics and law at the University of Alberta, and Philip Fernbach, a marketing professor at the University of Colorado at Boulder.

The study reached its provocative conclusion in several steps:

• The researchers showed that using the internet to answer questions leads people to attribute to themselves the knowledge they instead had obtained from the internet. That’s because, after using the internet to look up information, people will subsequently forget that they had done so. This phenomenon sometimes is referred to as the Google effect—the blurring of the boundaries between internal and external knowledge that leads “people to think they know more than they really do.”
• The researchers next showed that the Google effect leads investors to be overconfident. They demonstrated this by dividing a sample of investors into two otherwise identical groups according to whether they had access to the internet when taking a test of investment knowledge, and then providing each group with the identical investment challenge. After the investors had constructed their portfolios, they were asked how much money they would bet on their portfolios’ subsequent performance. Not surprisingly, the group that had access to the internet scored higher on their exams than did those not given access. And this higher-scoring group also bet more, on average, on the performance of their investment choices—indicating greater confidence in their investment abilities.
• This higher-scoring group’s overconfidence was misplaced, however. On average, the researchers found, investors in this group earned significantly lower returns than those in the other group. This phenomenon is the “confidence without competence” to which the researchers refer to their study’s title. The source of the higher-scoring group’s lower return appears to be their greater willingness to incur risks.

This new study reminds us of the dangers of overconfidence and the virtues of humility. But what I found most significant about the research—and most disturbing—is the pernicious way in which the internet leads us to increase our self-confidence without our even knowing that it is doing so. So even those of us who are trying to resist the dangers of overconfidence may still be led down the primrose path.

This consequence of the internet is not an accident, by the way. Sergey Brin, Google’s co-founder, said at a Google event in 2010 that “We want Google to be the third half of your brain.” The authors of this recent study interpret that statement to mean that Google blurs “the boundaries between the knowledge that resides in one’s head and the knowledge that resides on the internet.”

Investor beware.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.