Mar 23, 2009|
Be your own devil's advocate
In the previous article on 'anchoring bias', we discussed how analysts and investors have the tendency to get influenced by carelessly chosen assumptions. In this article, we shall examine another tendency called 'confirmation bias'.
What is confirmation bias?
As Francis Bacon once said, "It is peculiar and perpetual error of the human understanding to be more moved and excited by affirmative than by negatives."
One we have a notion in our head, we tend to selectively look for evidence supporting the notion. As they say, first impressions are the most lasting. Confirmation bias causes no harm if the initial notion or impression is correct. However, if it is wrong, the bias prevents us from realising our error quickly.
Like most biases, it has evolved due to practical realities. Real life data is often ambiguous and one has to pick and choose in search of meaning. In order to deal with the ambiguity, we attach more weight to evidence confirming our initial view than to those conflicting with it.
Shopping: After buying a garment, we will look for the same item in a more expensive store to confirm that our purchase was at a bargain.
Pet stocks: If an investor has had a good experience investing in a particular stock in past, he will find it difficult to form an unfavorable opinion even if the underlying conditions have changed.
Commodities: When crude oil futures were trading above US$ 100 per barrel, there were small reports of how oil tankers were floating around Iran and the off take of the commodity had slowed down. However, not much attention was paid at a time when some believed crude would touch US$ 200.
Avoiding the confirmation bias in stock picking
Admit: The first step in dealing with biases is to admit their presence.
Aggressively seek alternate ideas: One should read about various schools of investment thought, carefully examine them, and only then adopt one as their own. This will ensure that initial view itself is carefully chosen. In this case, even if confirmation kicks in, it doesn't cause much damage. As Warren Buffett says, "You need to fill your mind with various competing thoughts and decide which make sense...I remain big on reading everything in sight."
Play the devil's advocate: Having formed an initial view, one should systematically look for conflicting evidence. In fact, it is part of the scientific method - one forms a hypothesis and then systematically tries to disprove it. The famous British naturalist, Charles Darwin used to meticulously jot down evidence which went against his theories. Similarly, when it comes to stock picking, one should ask what could go wrong. Then, one should actively keep track of such events.
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