CONSIDER CONFRONTING YOUR CONFIRMATION BIAS
It might be difficult, but you’ll benefit as an investor, writes David Kaufman.
It is a universal element of the human condition that we seek out individuals who are similar to ourselves. People who share our values, traditions, culture, religious beliefs, political leanings, and even entertainment preferences.
The upside of this type of behaviour is that we tend to lead more enjoyable lives and feel more fulfilled because we are surrounded by others who validate our existence.
The downside is that we lead more sheltered lives with little adventure since we don’t feel the need to broaden our horizons or seek better alternatives to common challenges.
This myopic approach to life — what Wikipedia describes as “the tendency to search for, interpret, favour, and recall information in a way that confirms one’s preexisting beliefs or hypotheses, while giving disproportionately less consideration to alternative possibilities” — is called “confirmation bias.”
In life, confirmation bias will make you feel good about yourself but severely limit your ability (or inclination) to apply critical thought to any problem and evolve through knowledge and self-doubt.
In investing, confirmation bias will cost you money.
Virtually all investment decisions require some sort of fundamental analysis, including information gathering about things as broad as a country’s GDP or as specific as a company executive’s incentive package.
Through this study we are able to develop hypotheses about the movement in markets and a fulsome understanding of the interconnectedness between a vast array of economic and social metrics.
In order to make this type of endeavour more pure, science has, for many years, required strict guidelines regarding the collection and analysis of information in a laboratory setting to decrease the likelihood that research will be tainted by pre-ordained ideas and thereby increase the findings’ validity and probative value.
We need to do the same when doing investment research. While it is totally acceptable — indeed, almost necessary — to begin a search for the “truth” with a hypothesis (such as “lower corporate taxes lead to higher GDP” or “good corporate governance leads to higher stock prices”), it is equally important to avoid placing more weight (even unintentionally) on data and arguments that support the theory.
Whether screening stocks for potentially undervalued outliers, reviewing the strategy of a manager of venture investments or performing due diligence on a real estate transaction, it is always the case that a better picture of the true nature of the proposed investment will present itself when as much (or even considerably more) time is devoted to understanding why it might not work as to why it is sound.
The reason for this is that virtually all investments of even average quality will make money when the world unfolds as we hope and the sun shines. What good due diligence really requires is that we focus on what happens when plans go awry and the rain comes. In other words, the key question is not “How much can I make?” but “How much might I lose?”
And the answer to how much you might lose is much easier to determine only when you not only allow, but seek out, data and opinions that don’t support the theory from which your work begins.
Virtually all investments of even average quality will make money when the world unfolds as we hope and the sun shines.