Be a Better Investor – Overcoming the Confirmation Bias

01-07-2012

23 Jan Be a Better Investor – Overcoming the Confirmation Bias

Naver (www.stock.naver.com) is the largest online portal in South Korea. On top of dominating Korean language search and launching a wildly successful instant messaging service ‘LINE’, it also owns a financial services domain, with services including financial news, stock quotes, exchange rates, corporate press releases, reports and recommendations. Naver also runs the largest stock message boards in the country.

In 2010, Park Jae Hong and his team of researchers conducted a very interesting field experiment. Respondents were investors participating in online discussion forums. They were first asked to fill in a short questionnaire and to state their outlook on the stock in question. For example, if they were participating in a discussion on Samsung, they will be asked to rate the stock either as a strong buy, buy, hold, sell or strong sell.

The researchers then tied up with Naver to manipulated the forum by creating five new threads that appeared on the first page of the discussion board for the stock in question. Two of the threads had titles representing positive opinion about the stock, two were negative while the final one was neutral. Respondents were then told to click on any of the threads in order to answer three questions.

Their hypothesis was straightforward – people tend to seek out information that confirms their beliefs. And this was exactly what they discovered. Investors who had previously expressed a positive opinion on the stock would tend to click on the positive thread while investors who were bearish and had a sell call on the stock automatically clicked on the negative threads more. Results indicated that close to 60% of respondents exhibited this tendency.

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The Confirmation Bias is one of the most common behavior bias that influence our decision making process. In all aspects of our lives we favor information that is coherent with our beliefs. Consequently we also choose to disregard and overlook conflicting evidence.

When you are looking to buy a new car, you would think of all the positives associated with owning a car. If you have already more or less decided on a career switch, chances are you would enjoy dinner with friends who are supportive rather than friends who are absolutely against the move. When you are madly in love with your girlfriend or boyfriend, they can absolutely do no wrong in your eyes and anyone who says otherwise will be ignored.

In the attempt to alleviate the distress caused by conflicting opinion, we end up overlooking valuable information that ‘completes the picture’. This prevents us from making informed and balanced decisions.

As a trader and as an investor, it is paramount that we are able to make rational decisions. The moment an investor afflicted with the confirmation bias forms an opinion about a stock, a trade, the market direction or even an outlook about the general economy, he or she might start to dismiss conflicting information as irrelevant or inaccurate. The confirmation bias is often the reason why investors stick with a declining stock for longer than they should.

On the other hand, rational investors actively seek out opposing views so as to prevent themselves from falling prey to the bias. And no one understands the havoc confirmation bias can wreck on one’s investment better than Warren Buffet. He quoted Charles Darwin in an article he wrote for the Fortune magazine in 2001 –

Darwin used to say that whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants Man’s natural inclination is to cling to his beliefs, particular if they are reinforced by recent experience.

Practicing what he preaches, he went on to invite money managers with a negative view of Berkshire Hathaway stocks to the firm’s AGM in May 2013. In doing so, it is apparent he believes shareholders and most importantly he himself would benefit from conflicting views. (Doug Kass was the invited ‘Credentialed Bear’ for the meeting, but that is a story for another day).

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Like Warren Buffet, we can only rid ourselves of the confirmation bias by inviting our strongest critics and toughest opponents into our hearts and minds. Uncomfortable no doubt, but absolutely necessary.

 



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