confirmation bias

what it is

Confirmation bias is the idea that you analyze something, form an opinion—and then spend the rest of your time searching for data that support your initial conclusion.  Anything that doesn’t confirm your opinion, you simply ignore or attribute little significance to.

To some extent, everyone does this. And in many situations in life, you can argue that everyone should. What if Michael Jordan had accepted the fact he wasn’t good enough to play high school basketball?

But it’s one of the worst faults an equity investor can have.

I can see three reasons it’s so bad:

–it takes a long time to become thoroughly acquainted with a company you invest in. My experience is that it takes at least a year of watching management at work—and maybe a lot longer–to figure out whether they’re any good at running a company and whether their strategy makes any sense.

In practical terms, almost no one is going to wait twelve months after getting an idea before taking a position. This is especially true if the stock price is already starting to move up as more people discover the company’s possible profit potential.  So professionals always make provisional “buy” decisions.

For a considerable portion of a stock’s life in a professional’s portfolio, then, it’s more or less on probation, subject to being kicked to the curb if a deeper inspection of the company proves the initial impression to be wrong.

That never happens if the investor spends no time looking for leaks in the boat, or refuses to acknowledge they’re there as the vessel beings to list.

–the world changes. Markets become saturated. New competitors emerge. Old competitors improve their game. The business cycle advances from recession to recovery to expansion—and then back to recession.

In addition, stock prices change, both in absolute terms and for one industry group vs. another. …one stock vs. another within the same industry, too.

–companies change. Managements become more—or less—responsive to alterations in the competitive environment. Great companies reinvent themselves as the environment changes; merely good ones often don’t.

APPL, for example, was a failing personal computer hardware company. Then it became the iPod company. Then it became the iPhone company…

NOK was once an obscure, failing Finnish conglomerate. Then it was the world’s leading cellphone firm. Now it’s a mess…

where the problem arises

It’s unusual to see a working professional suffering from terminal confirmation bias. Normally, anyone infected is quickly fired. In places where office politics counts for a lot they may be kicked upstairs—not a great move for the organization’s long-term health. But it solves the short-term problem.

For private individuals, I think this phenomenon surfaces mostly as lack of awareness of how smart the market is—a naïve belief that after a brief perusal they understand more about a company than the people they’re trading with.

Professionals face a different issue. Your analysis says the stock should be going up. It’s going down instead. When do you concede that the market knows more than you—either about the company, the environment or the stock valuation?  No one wants to be scared out of a stock by adverse price action.  On the other hand, no one wants to be caught looking only for information that supports his position, either.

what to do?

Many professionals use mechanical rules.  For example, if a stock underperforms the index by, say, 15% (or some other fixed number), at least part of the position is sold–maybe the whole thing.

Others. like me, don’t like fixed rules and depend on aggressively seeking out negative information about the positions they own, instead.

In well-run organizations, the Chief Investment Officer plays a role here, creating an atmosphere where portfolio managers feel able to sell losers, as well as limiting the size of iffy holdings where he/she sees the question of what to do with an underperformer is likely to arise.

individuals in this situation?

Thinking about a 15% rule before buying anything would be my advice.

One response

  1. Pingback: Confirmation Bias and Trading | SMB Capital - Day Trading Blog

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