Categorical thinking can lead to investing errors, research finds

It’s impossible to explore every single stock in the stock market. Investors have limited time and attention and can’t investigate everything. That’s why they often try to keep it simple by choosing to study the value of an index rather than researching all of the individual stocks contained in an index.

But in placing their focus at a high level — whether on technology, automotive, or blue-chip stocks — investors may miss the nuances among specific companies within each category. And that can cause them to forfeit lucrative investment opportunities, saidRahul Bhui, an assistant professor of marketing at MIT Sloan.

Categorical thinking, as described by Bhui, involves using the broader category of an item (automotive stocks, for example) to infer characteristics about specific items within that category (General Motors stock). “Categorical thinking can be a double-edged sword because it helps us to rapidly make sense of the world, but at the same time can lead us to mistakes,” he said.

A new paper, “Attention Constraints and Learning in Categories,” co-authored by Bhui and Maastricht University’s Peiran Jiao, provides new insight on when and why investors focus on high-level categories rather than drilling down into the details of individual companies.

The researchers were motivated by the psychology of rational inattention — a theory that acknowledges that we optimize our attention within the constraints of our limited mental resources — as it applies to financial markets.

When time is of the essence, categorical thinking is the default

For their study, Bhui and Jiao created a stock prediction game where players were given a certain amount of time to make investments with abstract stocks in different categories. The game was not unlike the old Nintendo game called Wall Street Kid, Bhui said.

The researchers chose 883 participants from an online labor market and did not necessarily have investment experience. Participants were asked to estimate the values of hypothetical stocks after receiving information on the factors that could potentially affect the stocks’ value.

Bhui and Jiao analyzed participants’ decision-making via mouse-tracking, a method that measures a person’s computer mouse movements as they contemplate different options. The authors measured the amount of time spent mousing over each industry- or stock-specific factor and evaluated how these behaviors changed when properties of the environment were manipulated.

Participants were allowed to mull over any combination of stock indexes and individual stocks but had a specific amount of time to do so. In most cases, they had 12 seconds to gather information, though in one experiment, the time limit varied between 8 and 20 seconds.

The researchers found that those participating in the study relied on industry-level information when:

• They were given many stocks to evaluate.

• They had a short amount of time to complete their evaluation.

• All of the stocks were of similar value.

Armed with those results, Bhui and Jiao were able to draw the following conclusions and offer guidance to fund managers and investors.

When distracted or under pressure, investors are more likely to default to analyzing broad categories of stocks.

When pressed for time, study participants were more likely to default to broad categories. The authors believe that real-world investors respond in a similar manner. When external events cause investors to pay less attention to financial markets, they focus more on market-level information than on firm-specific information.

“When you’re really attention-constrained, you’re not fiddling around with the details of any individual assets that might be in a portfolio,” Bhui said. “You're going to think in broader strokes.” Examples of distracting events include international sports competitions, a pandemic, or a large lottery jackpot that day, he said.

Money managers should be aware that this can lead to increases of co-movement of assets in the same class, especially when investors’ attention is taxed in “thick” markets with lots of firms, analysts, and investors.

Examples of co-movement include when small cap stocks have correlated returns or when assets trading in the U.S. stock market have more correlated returns than do assets trading in the German stock market.

Some co-movement is natural, Bhui said, but inattention can lead to excess co-movement, which in turn can impede diversification.

When the market is volatile, investors may miss relevant information about individual stocks.

The research suggests that there are drawbacks to looking at categories instead of individual stocks. For example, while the whole biotech sector might be down, there may be one company in the mix that is still promising — an opportunity an investor might miss when distracted.

Focusing on aggregate information can have its drawbacks. As an example, Bhui cited the dot-com bubble: During that period, some companies added “.com” to the end of their name, without having changed their business model, and saw their stock price rise — even if their fundamentals weren’t good.

Fund managers should pay more attention to economic aggregates in recessions and to asset-specific stocks in booms.

Bhui said that previous research suggests that during a recession, when volatility is typically high, it makes more sense to focus on economic aggregates. In contrast, investors can take advantage of boom times and use the opportunity to evaluate individual stocks more closely.

“Money managers seem to do better when they [execute] this particular strategy,” Bhui said. “The idea is that when you have a recession, there’s a lot more volatility in the market and it’s a lot riskier so you really want to pay attention to the big picture and not focus on all the little details.”

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