Up third in my deep dive articles on the crucial behavioral biases to understand as investors is this one on confirmation bias. Similar to the other biases, confirmation bias has nuances that if understood can change our approach to investing. This ensures we are not victims of their pernicious effects. Recall that my ultimate goal is to have this series culminate in a Theory of Behavioral Finance.

A Helpful Mnemonic Device: LOCHAARM

To my mind the major behavioral biases are:

• Loss aversion
• Overconfidence
• Confirmation
• Herding
• Anchoring
• Availability
• Representativeness
• Mental accounting

A helpful mnemonic device for remembering these biases is LOC HAARM, brain lock that harms investment performance. Now to: confirmation.

Confirmation Bias: Origins

Like our two preceding biases, confirmation bias is something noted for thousands of years by commenters. Let’s let Thucydides, its oldest definer, have the floor:

“…it is a habit of mankind to entrust careless hope what they long for, and to use sovereign reason to thrust aside what they do not fancy.”^[1]

Ibn Khaldun, who many regard as one of the first formulators of economics^[2] said in his well-known Muqaddimah:

“Untruth naturally afflicts historical information. There are various reasons that make this unavoidable. One of them is partisanship for opinions and schools…if the soul is infected with partisanship for a particular opinion or sect, it accepts without a moment’s hesitation the information that is agreeable to it. Prejudice and partisanship obscure the critical faculty and preclude critical investigation. The result is that falsehoods are accepted and transmitted.”^[3]

More recently:

“[Confirmation bias] connotes the seeking or interpreting of evidence in ways that are partial to existing beliefs, expectations, or a hypothesis in hand.”^[4]

More colloquially, confirmation bias is described well by the old saying, “To the man with a hammer, every problem looks like a nail.” Hence, my chosen photo for this piece.

Confirmation Bias: The Evidence, In Brief

Researchers in psychology as well as in other domains have demonstrated confirmation bias is indiscriminate in its victims, plaguing academics and laypeople, experts and non-experts, alike. For example, researchers found that advanced undergraduate students when challenged to discover the laws of a dynamic system mostly engaged in confirmatory strategies. That is, they looked for information and data that supported their initial theses. This, despite the fact that they all were educated in methods of inference designed to minimize bias. Some of the science students even falsified results that confirmed their theses.^[5]

Not surprisingly, investors are not immune from confirmation bias. Researchers studied investor behavior in South Korea and found most investors on stock message boards displayed confirmation bias. Furthermore, they also found that those exhibiting greater confirmation bias also displayed the highest confidence in their decisions, too.

This is an important point. For the research analyst for whom a check on biases is not front of mind, because many of these biases interweave with one another, the result in a sum-is-greater-than-the-parts effect. Say bye-bye to excess returns.

Confirmation Bias: Nuances

Our Egos are Engaged

Elsewhere I have published what I believe are the Three Big Jobs of Investors. Because Job One of investors is to understand the world for what it is, and not what we would prefer it to be, confirmation bias is especially deadly. This is because confirmation bias directly engages our egos. Here is how…

Investment pros are paid, and typically well, for their opinions. A complicating factor is that our opinions are about things that may or may not occur at some indeterminate future point. Last, we are encouraged as investors to have conviction and confidence – in fact, it is specifically hired and fired for as a trait.

It Easily Combines with Other Biases

This combination is frequently a recipe for our preferences about how the world works (e.g. mental models) and prejudices (i.e. biases) swallowing whole our rationality. In other words, if our ideas about the future still have optionality our ego is still on the line.

It Triggers Hope

Last, confirmation bias triggers one of the perennial human traits: hope. Frankly, to me confirmation bias seems to be the intellectualization of hope as an emotion. Said another way, if we have rationales for our belief, we may easily convince ourselves that it is not hope, but logic, that keeps us hanging on to a cherished belief.

It turns out that there is a neuroscience of hope. Researchers have found that hope is a physical phenomenon.[6] They have also found that the emotion of hope is highly effective at reducing anxiety.[7] Is investing an activity that can induce anxiousness? You bet it is.

And here is the super interesting thing about hope, researchers find it in operation when an individual has goal-oriented expectations that involve agency (desire to achieve goals) and pathways (ways of achieving them). Does that sound like the arena in which we find ourselves as investors? Yup. One way to defeat confirmation bias is to learn to recognize what hope feels like and to check whether that is the foundation of your investment beliefs.

Confirmation Bias: Manifestations

Among the many possible sources of confirmation bias in our investment work are:

• Models. Any mechanical models we utilize in our work, such as screens or valuation models.
• Buys. Once we have purchased a security, until our investment thesis has unfolded fully, or even roughly, it is all too easy to justify any news as “noise,” instead of “signal.”
• Sells. Most investment firms do not track the quality of their sell decisions after the fact. Frankly, they turn a blind eye to the fact that it may have been the wrong decision.
• Management evaluations. Many fundamental investors form an opinion of management as a part of their process. Just like with a bad seed relative, it is easy to rationalize away witnessed bad behavior.
• Philosophies. Even our investment philosophies are formed to intentionally prejudice our world view against certain kinds of opportunities.

Conclusion

It is my opinion that confirmation bias contributes to the momentum effects so frequently found in investment narratives, in individual securities, and in whole financial markets. In other words, to master confirmation bias is to find alpha in “them thar biased hills.”

[1] Thucydides. The Peloponnesian War. E.P. Dutton. 1910

[2] From https://jasonapollovoss.com/web2012/01/09/losing-money-to-preserve-capitalism-can-we-afford-to-continue-bailouts-part-1/ accessed 19 September 2018

[3] Ibn Khaldun, Abd Ar Rahman bin Muhammed. Muqaddimah: Translated by Franz Rosenthal. US Islam. P. 5

[4] Nickerson, Raymond S. “Confirmation Bias: A Ubiquitous Phenomenon in Many Guises.” Review of General Psychology. Vol. 2, No. 2 (1998): pp. 175-220

[5] Mynatt, Clifford R., Michael E. Doherty, and Ryan D. Tweney. “Consequences of Confirmation and Disconfirmation in a Simulated Research Environment.” Quarterly Journal of Experimental Psychology. Vol. 30 (1973): pp. 395-406

[6] Wang, Song, Xin Xu, Ming Zhou, Taolin Chen, Xun Yang, Guangxiang Chen, and Qiyong Gong. “Hope and the brain: Trait hope mediates the protective role of medial orbitofrontal cortex spontaneous activity against anxiety.” NeuroImage. (2017) Vol. 157, pp. 439-447

[7] Snyder, C.R., Hal S. Shorey, Jennifer Cheavens, Kimberly Mann Pulvers, Virgil H. Adams III, and Cynthia Wiklund. “Hope and Academic Success in College.” Journal of Educational Psychology. (2002) Vol. 94, No. 4, pp. 820-826