This is a blog from Paul Craven, the amazingly talented and disarmingly modest ex Goldman Sachs Banker cum behavioural scientist. This is such a wonderful piece of writing that I’d value it, even if I didn’t agree with it. But I agree with it too – I’m not sure how I’ve got it on my email but – knowing Paul, I’m quite sure he wouldn’t mind me sharing this!
When Paul Simon wrote in The Boxer “Still a man hears what he wants to hear and disregards the rest”, he may not have been attempting profound economic analysis.
Yet that line from Simon and Garfunkel’s 1969 hit neatly sums up a phenomenon that dogs investors and economic commentators alike. It is known less lyrically as confirmation bias.
Witness the opposing political responses to most economic news. In 2014 when that UK gross domestic product grew 0.8% in the first quarter of this year, the Chancellor of the Exchequer, George Osborne, said that the rise showed “Britain is coming back” due to “our long-term economic plan.” The general secretary of the Trades Union Congress, Frances O’Grady, saw it differently. She said: “This is the kind of growth we could have seen two or three years ago if the government had not choked off recovery through cuts, austerity and wage freezes.”
In financial markets we can fool ourselves that we are being consistent when really we are filtering out data that does not support our investment premise, whether at the macroeconomic level or in the case of stock selection. Our natural inclination is to cling to our beliefs, particularly if they are reinforced by recent experience.
A study of 8,000 participants published in July 2009 showed that people are almost twice as likely to select information confirming rather than undermining their behaviours and beliefs. Indeed, confirmation bias is one of the most powerful of our 150 or so cognitive biases. We seek evidence that confirms our beliefs and ignore it if it does not.
The point to note is that we often do this unconsciously, at least until contrary evidence becomes overwhelming. As Warren Buffett puts it: “What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.”
Another study looked at investors who used online message boards to research a prospective stock; in most cases their searches were for information that only agreed with their view. The researchers wrote in July 2010: “In particular, investors with stronger prior beliefs are more likely to accept confirming opinions from virtual communities. Further, we find that investors with stronger confirmation bias have higher expectations about their investment performance, but they engage in excessive trading and experience lower realised performance. A natural interpretation of this evidence is that confirmation bias makes investors overconfident and overly optimistic, which results in lower returns on stock investments.”
People generally look for validation and external consistency – which is not always the same as looking for the truth.
An academic paper on confirmation bias by Raymond Nickerson described it as “a ubiquitous phenomenon in many guises” ranging from number mysticism and witch-hunting to government policy, the judiciary and science.
So what can we, as investors, do to avoid confirmation bias? In science, we often move closer to the truth by seeking evidence to the contrary. Buffett’s Berkshire Hathaway colleague Charlie Munger argues that the same methodology should guide our investment. He said: “The great example of Charles Darwin is he avoided confirmation bias… he always paid extra attention to the disconfirming evidence.”
Michael Mauboussin, head of global financial strategies at Credit Suisse, recommends a rigorous consideration of the alternatives and listening to opposite viewpoints. The psychologist Gary Klein suggests that market participants analyse the chances and circumstances in which their investment goes bust to test the strength of their previous assumptions.
These views may go against the grain for most investors, but challenging one’s beliefs often leads to better decision-making. One thing is certain: having a strong critical faculty helps. As George Soros said: “I am not a professional security analyst. I would rather call myself an insecurity analyst.”