Embracing Dissent: How confirmation bias can kill your investment returns

Monday, Jan 30 2012 by
7
Embracing Dissent How confirmation bias can kill your investment returns

Following the recent discussion on Prospect Theory and the ways in which human nature leads to systematic flaws in our judgement, we thought we'd spend some time looking at one of the most relevant behavioural biases for investors - namely confirmation bias. This is the well documented tendency of people to favour information that confirms their beliefs or hypotheses, not only by hearing what they want to hear but also by seeking out those with similar opinions. 

The (dangerous) power of YES

Confirmation bias has been observed in a very wide range of studies. In all walks of life, people seem to gather evidence and remember information selectively, and interpret it in a biased way. The Wall Street Journal cited a recent analysis with nearly 8,000 participants which found that people are twice as likely to seek information that confirms what they already believe as they are to consider evidence that would challenge those beliefs. Without realising it, we emphasise information which reinforces our view whilst tending to downplay, avoid or even ignore contradictory information. 

One study of biased interpretation took place during the 2004 US presidential election and involved subjects who described themselves as having strong feelings about the candidates. They were shown apparently contradictory pairs of statements, either from George W. Bush, John Kerry or a politically neutral public figure and asked to decide whether or not each individual's statements were inconsistent. The study found that subjects were much more likely to interpret statements by the candidate they opposed politically as being contradictory.

How this impacts investing

In the world of investing, confirmation bias can lead to all kinds of avoidable mistakes, be it trading too often and making inappropriate/miguided investments. An example might be an investor hypothesizing that interest rates will rise. Typically, he will then seek out information to confirm this hypothesis - understandably so - but, in the process, the danger is that he will lose out on analyzing important facts that may indicate that interest rates are in fact on the decline.  

Confirmation bias can also prevent us from objectively looking at an investment once we have already made it. Have you noticed that, as soon as you buy a stock, you start looking for reasons why you are right? Once a stock is bought, we tend to look for information that confirms the investment as a good one whilst ignoring information that may suggest that the investment is in fact bad or questionable. 

The risk in all of this is that reinforcing our decisions at the expense of new contradictory information can leave us “married” to bad choices that damage our financial well-being. An example of this bias can be seen in the way broker/analysts recommendations are shared and discussed on bulletin boards. Although this is rarely done, it is critical to regard broker recommendations with a grain of salt, understanding that they each have their own forecasting & bias troubles (such that they are often not worth the paper they are written on). Work by James Montier et al has examined the forecast accuracy of analysts:

In the US, the average 24-month forecast error is 93%, and the average 12-month forecast error is 47% over the period 2001-2006. The data for Europe are no less disconcerting. The average 24-month forecast error is 95%, and the average 12-month forecast error is 43%. To put it mildly, analysts don’t have a clue about future earnings.

Similarly, studies of recommendations have shown the stocks least favored by analysts earned an average annualized market-adjusted return of 13.4% whereas the stocks most highly recommended by analysts underperformed the market by 7.1%! 

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How to tackle confirmation bias in investing

Michael J. Mauboussin, the chief investment strategist at Legg Mason Capital Management, addressed the question of confirmation bias in his excellent 2009 book, Think Twice: Harnessing the Power of Counterintuition. To avoid being lured into the kind of tunnel vision that confirmation bias brings, he recommends a useful five point checklist:

  1. Explicitly consider alternatives - "You should examine a full range of alternatives, using base rates or market-derived guidelines". 
  2. Seek Dissent - "Much easier said than done, the idea is to prove your ideas wrong... When possible, surround yourself with people who have dissenting views". Not everyone with an alternate opinion is a troll!
  3. Keep track of previous decisions - "We generally fail to consider enough alternatives looking forward and think we knew what was going on looking backward. The antidote to both is to write down the rationale behind decisions and to consistently revisit past actions. A decision-making journal is a cheap and easy routine to offset hindsight bias and encourage a fuller view of possibilities".
  4. Avoid decision-making while at emotional extremes - " Making decisions under ideal conditions is tough enough, but you can be sure your decision-making skills will rapidly erode if you are emotionally charged". 
  5. Understand incentives  -  "Financial incentives are generally easy to spot, but nonfinancial incentives, like reputation or fairness, are less obvious [but] the evidence shows that the effect can be subconscious". 

In his book, "Sources of Power: How People Make Decisions", Gary Klein suggests using the "crystal ball" technique can help people become sensitive to alternative interpretations of the facts. The idea is that to assume that your investment has gone bust in, say 6 months, and then come up with the most compelling explanations you can find for the failure. This exercise can help expose the (otherwise missed) flaws in your thinking.

Alternatively, Maubossin emphasises the importance of expected value thinking (including downside scenario analysis) to provide "psychological cover for admitting that you're wrong": 

"Say you’re an analyst who recommends purchase of a stock with a target price above today’s price. You’re likely to succumb to the confirmation trap.... If, in contrast, your recommendation is based on an expected-value analysis, it will include a  downside scenario with an associated probability. You will go into the investment knowing that the outcome will be unfavorable some percentage of the time. This prior acknowledgement, if  shared by the organization, allows analysts to be wrong periodically without the stigma of failure".

Common to many of the greatest investors (e.g. George Soros) is a search to engage with contrary opinions. A lot of the thinking behind Stockopedia Premium is intended to provide you with data-centric visual indicators that can challenge your own assumptions about a stock's past performance and prospects.

In your own investing, it's well worth remembering to seek out the true financial realities of your stocks, scanning checklists for red flags and opening your thinking to public criticism via our Forums for example (and, of course, listening carefully to the responses before dismissing them!). 

Further Reading


Filed Under: Psychology, Confirmation Bias,
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2 Comments on this Article show/hide all

emptyend 31st Jan '12 1 of 2
3

There is obviously a lot of truth in the confirmation bias issue, but it is often difficult to apply meaningful corrective action, especially when considering whether stock-specific matters will dominate macro issues or vice versa. In particular, one should ALWAYS remember that equities and individual stocks are NOT the only game in town!

I am particularly reminded of a conversation with a well-known M&G fund manager, who was regularly asked for his investment tip for the following year in annual newspaper reviews in the 1980s. He always suggested "cash" - not because he really believed that it would outperform, but because it provided a sensible benchmark for individual investors.

If one looks at the last few years since 2007/8, there can be little doubt that macro issues have dominated returns....so, for example, not only have banks vastly underperformed, but so have retailers, builders, brewers, real estate, recruitment, bookmakers, transport and telecoms providers. No amount of unbiased analysis would have saved investors from losing money in banks and financials if that was the sector they chose to invest in - and very few of the other poorly-performing sectors have seen individual stocks make gains.

So......the most relevant form of confirmation bias that has impacted returns over the last 4-5 years was, in essence, the widely-shared belief that the debt-fuelled boom would continue - rather than hit the buffers spectacularly, as it did. 

This leads me to point to one of the biggest marketing myths of the last 20 years - which is that long-term investors should own equities in preference to all other asset classes. This was observably correct advice from broadly the mid-1970s (if not earlier) through to about 2000....but since the tech boom hit the buffers in March of that year, the "place to be" in equities has actually been pretty narrow.....in commodities (especially gold), resources and fixed income (except most of the Eurozone!!!), classical defensives (tobacco, pharma, brands).....and very little else! Though who would have guessed that luxury product groups would also do so well against that backdrop???

So when you talk about "being married to bad choices", that pretty well includes everyone who has been over-exposed to equities as an asset class [even those such as me who have attenuated their exposure to equities by being long of resources stocks (often the wrong ones, ex-post) and fixed income]

The present risks of confirmation bias are rather different. Most people seem to think that the Eurozone is simply to be avoided, that the global economy will remain weak and that equities will continue to underperform. Therefore they look for the negative aspects of any news (see the recent press comments on Executive pay and financial matters generally).

I'm not so sure that equities are indeed to be avoided! There are vast amounts of cash on the sidelines, both on corporate balance sheets and in fund holdings of cash and bonds......if and when confidence in the markets can be picked up off the floor (and it WILL happen at some point, unless the Occupy lobby manage to destroy capitalism), then there should be a good base for quite a long and powerful rally.......

...but, as ever, the question is when? Just because stocks are cheap (and they now are) doesn't mean they can't get cheaper - especially if sentiment remains determinedly against them, aided and abetted by a relentless negativism in the media etc

At least there is one aspect of confirmation bias I can't be accused of falling for:

An example of this bias can be seen in the way broker/analysts recommendations are shared and discussed on bulletin boards. Although this is rarely done, it is critical to regard broker recommendations with a grain of salt, understanding that they each have their own forecasting & bias troubles (such that they are often not worth the paper they are written on).

;-)

I use a bucket of salt, myself .....

ee

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timarr 31st Jan '12 2 of 2
2

Confirmation bias is a nasty problem, but it's very difficult to overcome because it's programmed into the way we think. Both neoclassical economics and Prospect Theory assume that we make decisions by performing an exhaustive search of all of the option available to in order to "maximise our utility" - usually assumed to be "profits", although Prospect Theory makes the additional assumption of bounded rationality - i.e. we are unable to rationally process all of the information because of limited processing power.

Most of us probably wouldn't recognise this as the way we make decisions; mainly we search through the options we can bring to mind before selecting the one that seem to best fit our situation. The more familiar we are with the situation the more likely we are to operate in this way. This is in accordance with the ideas of Herb Simon, who proposed that we make decisions by satisficing - making "good enough" decisions. Gerd Gigerenzer has developed this idea into some actual research with interesting and suggestive results - which also seem to disprove some of the basic findings of Prospect Theory.

Now if this is the way we make decisions - by searching for something that's "good enough" we're highly likely to suffer from confirmation bias, because we don't generally look for disconfirming evidence: it's completely foreign to most of us. The only real way around this is to develop processes that we follow - checklists for instance, that we train ourselves to follow. Of course we can then become over-familiar with the checklists.

http://www.stockopedia.com/content/satisficing-stockpicking-investment-decision-making-herbert-simon-45448/

timarr

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