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%!
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:
- Explicitly consider alternatives - "You should examine a full range of alternatives, using base rates or market-derived guidelines".
- 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!
- 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".
- 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".
- 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 PRO 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!).