Blind spots and confirmation bias
We talk a lot about perspective in this column. Our perspective is the lens through which we view the world. It is our way of framing everything we see and ultimately defines how we react to what life throws at us.
We believe what we believe because of our past experiences and perception of reality. In finance, investors often share their perspectives (albeit usually too much), which gives us untold insight into how people may be thinking at any given time.
The perspective du jour is that markets are not accurately pricing honest valuations (i.e., stocks are overpriced). But is this accurate or a blind spot in our perspective?
Confirmation bias is defined as the tendency to process information by looking for or interpreting data consistent with what you already believe. We all have a level of confirmation bias if we look in the mirror. Where you get your news, information, and even relationships is based on your political leanings, upbringing, religion, and a million other minute factors that help make you, you. Because human
To contact the business department: 303-954-3515 Fax: 303-954-1334 Local — Lookup — My Portfolio nature shows a preference for information that agrees with what we believe to be true, we tend to favor views reinforcing decisions we’ve made. We want others to tell us we made the right decision. We hear what we already believe.
Some 50 years ago, Nobelprize-winning author Daniel Kahneman and Amos Tversky wrote groundbreaking material based on a central thesis: A consistent misperception of the world governs people’s intuitive expectations. In other words, people believe what they believe based on their perceptions, not necessarily on facts.
Confirmation bias represents a huge blind spot for investors. Consider our earlier question: Are markets overpriced right now? The typical misperception is that as stocks get more expensive, they become more valuable. Said a different way, people tend to want to invest more in companies that have seen an increase in their share price. In turn, this leads to more and more investors “chasing.”
I find it odd that we process prices and value in all other areas of our life almost exactly the opposite. Think end-of-yearclearances on cars and trucks, January white sales, even Amazon’s business@denverpost.com
Prime Day. Whenever prices are discounted in the consumption economy, we get excited and mentally feel the value of what we are buying is getting better. We lean into our purchases when prices go down. When things go on sale, I go shopping. We apply this perspective to managing investments for our clients.
Yet investors tend to do the opposite. Cullen Roche wrote years ago, “The stock market is the only market where when things go on sale … all the customers run out of the store.” This behavior is driven by the misperception that as prices go down, the value goes down. Kahneman and Tversky were right: it is a consistent misconception of the world. Selling your investments in companies after they are lower is the ultimate unforced error in investor behavior — yet it seems to be human nature and happens repeatedly.
The best evidence of this is to look at the flow of funds, a measure of how investors and their advisers are allocating or investing their money over time. On Feb. 19, the S&P 500 closed at a new all-time high of 3,386.15. Over the next 16 weeks, COVID19 hit the equity markets resulting in a fall of about 34% in just 33 days. The speed of this correction is without historical precedent. The following 50 days saw the fastest and steepest bounce in American history. According to data published by the Investment Company Institute, investors were net sellers of some $171 billion in equities and net buyers of $1.1 trillion in money markets from January through May. The same data says about $4.8 trillion sitting in money market accounts at the end of May. That’s a lot of cash earning nearly zero return.
Confusing short-term prices with long-term values is a classic investor mistake. Judgment is clouded by the blind spot of our own confirmation bias. This mistake affects seasoned pros and new investors alike. In May, billionaire investor Stan Druckenmiller, proclaimed, “The riskreward for equities is maybe as bad as I have ever seen it in my career.” As the markets surged some 40%, his portfolio returned about 3%. He pronounced himself “humbled.”
Even Warren Buffett is not immune from blind spots and confirmation bias. Historically Buffett argued investment in the airline industry to be foolish. He once said that if a capitalist were at Kitty Hawk, they would have shot down Wilbur Wright. Berkshire Hathaway accumulated some 10% of the airline industry in recent years, only to turn and liquidate those holdings in March at their low prices. Even someone like Buffett, nearly knighted for his investment acumen, may need investor behavior reminders.
Are stocks overpriced? That’s a wildly generic question with no clear answer. But as you consider whether to invest or not, take heed of your blind spots and question whether you’re using confirmation bias to reinforce your beliefs and judgments. Consider different perspectives and arguments that may challenge your views. Ultimately, it’s up to you as an investor to decide whether things are overpriced. Your perspective will be the deciding factor, so make it as informed and unbiased as possible.
From denverpost.com, click on Business Section, then Stocks: