Confirmation Bias – Behaving Rationally In An Irrational Environment by RichardsonGMP

By Craig Basinger, CFA; Gareth Watson, CFA; Derek Benedet, CMT; Chris Kerlow, CFA; Shane Obata

All trading that is not completely systematic has some degree of emotion involved. Stock prices fluctuate way too much to be attributed solely to rational changes in the valuation of the company. In this, our first of several pieces on the behavioral biases inherent in investing, we discuss how to avoid or mitigate these shortcomings in which your emotions may inhibit investment returns. We also touch on ways to exploit these deficiencies to profit from when others fall prey to their behavioural fallacies.

There are have been many investment behavioral biases discovered over the years. Behavioral finance literature really began in the 1980s with researchers developing behavioural models to test their theories. This has evolved to analyzing Google searches, brokerage account logins and now even MRIs that use neuroimaging to better understand the cognitive mechanisms involved in trading (we may hook up the team next week to see how our brains work). If you have ever bought a stock, you can relate to the thoughts and emotions you experience that start right when you have that eureka moment and think of the great investing idea. It doesn’t stop there, you are emotionally vested throughout the entire due diligence process, the deliberation on how to execute and then the day-to-day tugging on your heart strings as the price fluctuates up and down as you try to decide whether to hold on or sell.

Behavioral Finance
Image source: YouTube Video Screenshot

Being professional money managers addicted to our craft, we have done extensive research and study on this glaring deficiency and ripe opportunity present in the market. Even the Chartered Financial Analyst (CFA) designation program dedicates a substantial amount of the curriculum to teaching about behavioral finance.

Unlike the Olympics where only the world’s elite are granted the opportunity to swim in the pools in Rio, the stock market welcomes investors of all levels of ability and experience. Behavioral biases appear to be most dangerous for investors when their process lacks discipline and structure to help offset these investment pitfalls.

Behavioral Finance, Confirmation Bias

This week we will focus on one of the most common and prevalent behavioral issues, confirmation bias. At the root of it, once investors have mulled through their research and executed a trade, they have convinced themselves to some degree that their thesis for investing in the stock is being underappreciated by the market and it is only a matter of time before other investors recognize the opportunity and bid up the stock to its true intrinsic value. The problem is that their research and homework, which resulted in a commitment of their hard earned capital, blinds them to the fact they could be wrong. Subsequently what happens is referred to as asymmetrical or reinforcement learning, good news is overvalued reinforcing your investment theory and bad news is discredited of its importance. The outcome of confirmation bias is that investors will bid up stocks or increase their intrinsic value on superficial information. On the other end they hold on to stocks longer than they should as negative news drives down the price. There is a strong relationship between the level of your misplaced overconfidence and the potential for losses to seriously add up.

If you have ever seen a stock in your portfolio soar to levels you couldn’t imagine only to come crashing back to earth (try to think of a Canadian health care stock) or held onto a loser way too long, you know what I am talking about. Even as professionals we still find this shortcoming as a very natural instinct. The good news is that this behavioral bias can be combated by implementing a few checklist items into your investment process. The easiest is setting target levels both on the upside and downside. Once those are breached force yourself to do a thorough examination of the thesis as to why you bought the stock. If the thesis has played out and the stock is close to your target it is probably a good time to sell and redeploy the capital to another idea with better upside. If the stock has broken through your downside level, and the thesis you initially invested in appears to be intact you might be missing something. I find it useful to read the most bearish sell side research report I can get my hands on or scour public financial literature websites like Seeking Alpha or Zero Hedge to understand why the stock is so disliked by investors. This will often help you see the other side of the story and open your eyes to what is fundamentally not working with your idea. If it doesn’t, it is probably an opportunity to top up your position because the story is just taking time to play out.

We seek out these deficiencies in the market and attempt to exploit them by paying particular attention to stocks that are either in severely overbought or oversold levels and look to be trading contrary to either the news or our future outlook. Increasing the degree of your objective evaluation will certainly reduce the degree of subjective opinion which is our best way at combating this specific behavioral bias.

Some useful questions to ask yourself to defend against confirmation bias.

What key assumptions am I making?

What factors could change to make these assumptions either exceed/or fall short of their projected value?

Have I actively sought out a contrary opinion?

What are the key aspects that are the basis of the contrary opinion?

Do I still disagree? Why?

Charts are sourced to Bloomberg unless otherwise noted.