Too Much Public Information Undermines Investor Decisions

Study finds cause for banning public investment advice

UNIVERSITY OF CALIFORNIA, BERKELEY'S HAAS SCHOOL OF BUSINESS—Are investors “mad” to follow CNBC’s Mad Money show host Jim Cramer’s stock advice? Would they be better off without media’s insights?

When investment information is public—such as being broadcast to thousands of viewers—all that “noise” excites investors and causes them to lend more weight to the information than they should, even when the quality of the information is low. As a result, new research suggests that society may be better off making the public release of such information—illegal.

“People put an enormous amount of weight on information delivered via the media. As a result, we found that investor behavior becomes more random and investors become less likely to use the information in an optimal fashion to price the stock,” says John Morgan, an economist at UC Berkeley’s Haas School of Business. “The cost of our markets functioning based on mispriced stocks is greater than the benefits of having public information.”

In the working paper, “Experiments on the Social Value of Public Information,” Prof. Morgan and co-author Donald J. Dale of Muhlenberg College suggest that policymakers must balance the costs of transparency—meant to maintain accountability—with the effects of distorted information.

“The ‘echo chamber’ effect of public information can ruin the way the market should function,” says Morgan.

Media critics began challenging the “CNBC effect”—the result of noise, confusion, and incomplete information—in business journalism during the beginnings of the subprime crisis a decade ago. The phenomenon revealed that new sources of information, such as Mad Money, could move investor sentiment to depend less on stock fundamentals and become more reliant on the public information provided by the press.

“Without public information, each investor would only have a little private information,” says Morgan, referring to the kinds of insights shared privately by people whom investors consider to be knowledgeable of the industry or product. “If you add a new source such as Mad Money, even if it’s a poor source about fundamentals, you know that everyone else will hear it, and this can trump your private information.” Investors therefore are inclined to follow what’s popular.

Because the researchers wanted to make sure that the results held true among the general population, and not just sophisticated stock traders, the researchers used a subject pool of undergraduate college students.  

The participants were first given two types of private information or signals in a stock trading game: high quality/reliable and low quality/less reliable, correlating with fundamentals information (a stock’s intrinsic or true value, not market value) Later, they were given public information. Participants tended to overweight the low-quality information in all rounds of the experiment.

The signals were indications of the true value of the firm, but always reported with error,” says Morgan. “One of the signals was less error-prone than the other and the subjects paid too much attention to the more error-prone signal.”

When the participants were given a modest amount of public information— enough information that a layperson could use it to his or her benefit—the participants consistently over-weighted the public information, resulting in a lower payoff.

The payoff for each participant was determined in two ways: 1) by the difference between one’s choice and the average of all choices, and 2) by the difference between one’s choice and the true fundamental value of the firm. A firm’s true value, according to finance theory, represents the net present value of its future cash flows.

“It places investors on the horns of a dilemma,” says Morgan. “We would all be better off cooperating but our individual interests are strong. If everyone else is following the news story, then most people think the best thing they can do for their investment strategy is to follow along even if they know they may be wrong.”