Friday, July 24, 2009

Why Confirmation Bias is so Tough to Counteract

According to the website Science Daily, confirmation bias is defined as:

“[A] tendency to search for or interpret information in a way that confirms one's preconceptions, leading to statistical errors”

Now that may be a lit bit too technical of a definition for some tastes. In more plain English, conformation bias refers to the tendency to look for information that supports what you already believe. An additional manifestation of this bias rears its ugly head when people automatically dismiss information that is contrary to their previously formed views on a subject. Let’s start with a very simple example. Assume that you believe that the Fed’s recent monetary policy actions will inevitably lead to inflation. Not being aware of confirmation bias it is very likely that you would be prone to searching out data and arguments that agreed with you on the inflation issue. You would read Simon Johnson’s blog and put together your own narrative on how inflation will come about. You would look at David Einhorn’s and John Paulson’s large purchases of gold bullion as evidence that the smart money was on inflation. You might follow John Hussman’s lead and start purchasing TIPS for your own account. In other words, it would not be hard at all to find a number of people who agree with you and who make a very logical case that inflation will eventually be on the horizon.

The problem with succumbing to this bias, whether you are aware of it or not, is that there are very few things in life that are completely certain. Other than death, taxes and Goldman Sachs’ (GS) exorbitant profits, most things are more nuanced and ambiguous. By only focusing on information that confirms your convictions, you are by definition ignoring the other side of the argument. And no matter how sure you are that your thesis will eventually play out, there is always a piece of contradictory evidence or someone out there who can make a credible case for why you are wrong. Continuing the inflation example from above, there appear to be just as many intelligent arguments that deflation is a much more proximate risk. Thus, if you limited your analysis you would be ignoring the views of people like Paul Krugman and San Francisco Fed president Janet Yellen who have detailed the ever-present risks of deflation in an environment of falling wages and asset prices.

Sadly, despite the fact that I am well aware of this innate tendency and am even on a first name basis with it, I find it very hard to shake the habit of searching out only the information that is confirmatory. Even worse, I tend to give arguments that support my view much more credibility than those that do not. I sometimes find myself looking for reasons why the author or the source of opposing information is either biased or just flat out wrong. It is when I get a little rush when I read that someone I respect agrees with my analysis that I fully understand the magnitude and power of this bias. Even more troubling, I have to admit I often feel a little down when my thesis appears to not be playing out or when I read that an investor I look up to has taken the opposite position.

The bright side of all of this is that I am aware of my proclivity to dismiss views that don’t mesh with mine. In fact, I am so cognizant of my biases that I force myself to seek out information that reflects a conflicting opinion (irrespective of how much it pains me) in an attempt to be well-informed regarding that factors that will ultimately influence who is right and who is wrong. By doing this I hope to be able to avoid falling in love with my beliefs. An investor who automatically rejects an argument that he or she does not agree with risks becoming stubbornly and foolishly stuck in an unprofitable position. Investing is so dynamic that skilled participants must being able to change their asset allocation on a dime. Accordingly, understanding an issue from multiple perspectives allows a person to buy or sell a position as a result of news or fundamental changes in the markets that indicate that the initial investment thesis was incorrect or mistimed.

Of course I am not advocating forsaking investing discipline at any hint of the potential for loss. Especially on the short side, it often takes a long time for the fundamentals to catch up to the asset price. Patience will always be a virtue when it comes to investing. However, it is important to avoid becoming too married to your positions and views. I think another example of my own battle to overcome my biases highlights why flexibility and open-mindedness are such crucial attributes of successful investors. As many of you know, the sector I follow the closest is the regional banking sector. I believe my familiarity with the companies and the factors that influence share prices gives me an advantage over less knowledgeable investors. As a result of my extensive research I have been incredibly bearish on the regional banks since the end of 2007 when it became obvious that a deteriorating economy and poor underwriting standards were going to saddle these companies with millions of dollars of toxic loans. In hindsight, that was a very good time to be advocating the short selling of these banks as just about every one I recommended experienced a dramatic fall in share price.

Specifically, I used to joke that identifying troubled banks was like shooting fish in a barrel. California residential construction exposure? Borrow as many shares as possible! Florida condo loan portfolio? This thing could go to zero! Despite the fact that a lot of the calls I made ended up being right (and yes, some did go to zero), it completely biased me against the sector. Knowing the fundamentals of these companies, I could not even come up with an argument for why anyone would want to own the stocks. In the process I forgot Buffett’s rule that any company can be attractive at the right price. I was so jaded by my analysis that when the bank stocks reached valuation levels that implied that the whole industry was insolvent I was paralyzed. Instead of using my knowledge to help me look past the Armageddon scenario, I just sat there and watched the stocks fall, unable to react to the unprecedented valuations.

Well, since then some of these stocks have doubled or tripled off of their March 2009 lows. I tell myself that there was the risk that some of them could have gone to zero without the government’s help, but that does not justify my inaction when it came to companies that would have inevitably survived the crisis and may have come out stronger as a result of the destruction of the competition. What this painful lesson has taught me is that investors can’t be seduced by what the market is doing or by the most commonly held beliefs. Just because a stock continues to rise or fall, that should not necessarily tell you anything about the company. Taking your cues from Mr. Market is a great way to lose money or miss out on once in a generation opportunities. Similarly, focusing your attention and analysis on data that confirms your already developed beliefs puts you at risk of missing or flat out ignoring information that indicates your thesis is wrong. Only by being aware of the potential impact of the confirmation bias and proactively working to offset the associated tendencies can investors avoid painful and costly errors.

(Picture of Janet Yellen courtesy of the Federal Reserve Bank of San Francisco)