Tuesday, 5 June 2012

Stop agreeing with yourself: Overcoming Confirmation Bias in Investing

In an experiment people are told that the following sequence; 2-4-6 conforms to a rule. Their job is to work out the rule by selecting sequences of three numbers which they are then told works or does not. Initially people see the rule as going up by 2. To test this they will select sequences like 8-10-12, or 50-52-54, once they are told that these fit the rule they will happily deduce the rule is sequences that go up by two. However, on this front they are wrong, the actual rule is any three ascending numbers so not only do the examples above conform but also 1-7-109 or 1-2-3 do too.

 The reason people rarely work this out is because they look to confirm their current theory instead of testing numbers that could falsify their theory. The confirmation bias.

So, we look for confirmation of already held beliefs. How does this affect our ability as investors?

Well, say you think apple may be a great buy so you are far more likely to dutifully type into google "is apple a great buy" or "reasons to buy apple" than "reasons not to buy apple" or "is apple a bad buy". Or, if you are an equity analyst poring over financial statements and industry data you are again in the vast swath of data likely to find evidence to support the position you already hold (buy, sell or hold) rather than counter it.

You are probably thinking that this is a very good way of understanding how other people behave, but not me. I'm far more impartial, I can let the evidence speak for itself. Sadly, this perspective is a deluded as the little boy jumping off his sofa, thinking if he can flap his arms fast enough, he may be the first human ever to fly. We are human which makes us both irrational and incapable of aidless flight. So, however hard we flap our metaphorical brain arms there is no getting around this fallibility. We do this, you do this, no one specially gifted with full rationality.

So, if you choose to accept your not a special case, what is the answer.

Well, it's impossible to overcome these biases in all areas. However, if we ingrain counter-intuitive thinking into our processes (and ensure we don't skip them) then it's possible to protect ourselves. Here is what I would suggest;

1.) Have a set procedures when making an investment and build into this the requirement to look at the dissenting view. (i.e force yourself to research and write down 5 possible negatives about the stock before purchasing)

2.) Carry out a pre-mortem.  This is done by imagining yourself 5 years in the future and the investment has gone badly. You generate ideas over what has caused this, possibly alerting you to weaknesses you may have overlooked.

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