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Here’s a quick test...
Let’s say I offer you this sequence of numbers - 2-4-6 - and ask you to figure out the rule that I used to create it. All you need to do is suggest some more number sequences to see if they fit my rule. I’ll tell you if they do or they don’t.
What might spring to mind - and studies show that it often does - is an obvious answer like 8-10-12. That does fit the rule, but what’s the rule? It seems a sure thing that the rule is something like adding 2 each time, but it isn’t.
You might now be tempted to make various other guesses at upward sequences of numbers trying to figure out what this damn rule actually is.
A much less obvious answer would be something like 5-3-1. It’s almost inevitable that this sequence would never work and so it’s utterly pointless suggesting it. Indeed, it doesn’t fit the rule - but that’s a big clue to the answer.
My rule is is that the sequence is just made up of ascending numbers, whether it’s 1-2-3, 2-4-6 or 57-65-133 - any upward sequence will do.
This test was created in the 1960s by a British cognitive psychologist called Peter Cathcart Wason. He found that the subjects of the 2-4-6 test often come up with more specific answers than they need to. Moreover, in trying to work out the rule, they usually offer guesses that fit what they already assume the answer is. This and other tests supported what Wason called Confirmation bias.
Confirmation bias is the tendency for individuals to look for and interpret new information in a way that confirms what they already think or believe. It weaves its way into many areas of human activity, from how we interpret online reviews to the ways in which doctors make a diagnosis. But one particularly worrying aspect of this behaviour is how it affects stock market investors. In simple terms, we’re at perpetual risk of falling in love with stocks and refusing to have a bad word said about them!
Confirmation bias generally rears its head after an investor has made an investment decision. That’s the view of Michael Mauboussin, the managing director and head of Global Financial Strategies at Credit Suisse and co-author of Expectations Investing. He writes that: “...once investors purchase a stock, they seek evidence that confirms their thesis and dismiss or discount information that disconfirms it. This leads to a loss of objectivity.”
Not only is objectivity lost, but investors suffering from Confirmation bias may also be straying into other associated behavioural traps that have been shown to damage returns. They include:
Digging into the reasons why Confirmation bias exists, equity strategist James Montier points out that we’re twice as likely to look for information that agrees with us than we are to seek out disconfirming evidence. In The Little Book of Behavioural Investing, he says that we generally read and meet people with ideas closest to our own. He writes: “It makes us feel warm and fuzzy as human beings to have our own ideas repeated back to us and at the end of the meeting we can all leave agreeing that we are all very smart.”
Montier’s words may well resonate with investors familiar with internet message boards. Given the explosion of online information, research, tips and opinion on stocks in recent years, it’s possible that investors are becoming increasingly prone to falling for Confirmation bias. In fact, one recent study in South Korea found exactly this.
It discovered that investors exhibited Confirmation bias when they processed information from internet message boards. Those with the strongest Confirmation bias also showed the greatest overconfidence. They had higher expectations about their performance, traded more frequently, but ultimately achieved lower realised returns.
As a quick aside, among the reams of academic research in this areas, there’s an interesting study worth mentioning by UK researchers who looked at how ‘value’ and ‘glamour’ investors might be influenced by Confirmation bias.
The main thrust of the findings are that, due to Confirmation bias, a typical value investor reacts to good news slowly, while bad news is often reflected fairly or even too quickly. In contrast, in a glamour context, the release of good news is expected, so it is often reflected instantly or even too quickly into stock prices, while bad news travel too slowly.
To counteract the influence of Confirmation bias in these strategies, the researchers suggest that that value investors ought to focus on using fundamentals to find financially strong, cheaply priced stocks. They refer to these shares as “dusty gems”, but Stockopedia users would recognise them as Contrarians. Meanwhile, they say that analysis of glamour, or strong growth firms, ought to focus on avoiding those that are performing badly. They refer to these - as we do - as Falling Stars, or previously good companies that have hit problems.
The interplay between quality and value is an interesting spin on understanding how investor behaviour can influence the performance of some stocks. But more broadly, there are some key points to remember when it comes to avoiding the Confirmation bias trap. A good starting point is to consider the words of David Dreman, an investing legend and arch contrarian. In his book Contrarian Investment Strategies: The Next Generation, he wrote:
“Investors, even professionals, fall prey to important logical fallacies and psychological failings… The bottom line is that these powerful forces lead most people to make the same mistakes time and again. Understanding them is your best protection against stampeding with the crowd, and perhaps profiting from their mistakes instead.”
On that note, here are a few ideas from the vast commentary on this subject:
We’ve written previously on Confirmation bias here, and you can follow our developing library of behavioural finance articles here.
About Ben Hobson
Stockopedia writer, editor, researcher and interviewer!
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Unless you are really just suffering from confirmation bias. This article is really about cheese.
The example cited here - what's the rule underlying the 2-4-6 sequence? - seems to me to be a very poor example indeed
In the discussion the rule is revealed to be simply that each number is higher than the one before - so the numbers 11 - 1354 - 200001123 might also be outcomes of applying the same rule.
The commentary says that people who incorrectly infer that the rule is to add 2 to the previous number are displaying cognitive bias.
BUT BUT BUT the logic of that assertion is fallacious.
Anyone who has any mathematical background is well aware that there will generally be several alternative algorithms which yield the same values over a small range. eg 2,3,5 could be terms of the sequence (n+2) or could be adjacent primes. It is impossible to be sure which rule applies unless further data points are provided.
When confronted by situations where there are multiple different rules that might underlie the data, what comes into play is our understanding of probability. We instinctively discard low probability explanations in favour of higher probability explanations.
So in effect we ask ourselves if the rule is that each number is higher than its predecessor, what are the chances that we end up with 2-4-6?
The answer is vanishingly small - it's effectively 1 divided by infinity. That's why we do not bother to consider it.
I have no problem with the concept being expressed here - the unconscious biases we all have. But I think you need a better example.
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
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"A man sees what he wants to see, And disregards the rest".
Paul Simon, The Boxer.
Great article, Ben.
Confirmation Bias destroys objectivity, kills one's willingness to gather information & leads to delusion.
In short, it may be the single most significant differentiating factor between success & falure as an investor.