It is a well-known fact that the human race in general, and those of us who invest in particular, suffer from a broad range of biases – some of which can even be detrimental to your well-being and/or bank account.
The one I want to explore in this discussion is the so-called confirmatory bias. It can manifest itself in a few ways, for instance, as the unwillingness to change your mind when the facts change. It can also cause you to misinterpret evidence that goes against the opinion we have already formed about a given stock, which causes investors to become overconfident. In short it makes you unable to view the facts in the correct light, because you have already made up your mind.
In my humble opinion this is one of the biases that can cause the greatest damage to your investment performance. First and foremost is the possibility that you might increase your valuation of a given stock if you misinterpret or overlook evidence but also because you might not realize that the stock is actually not worth as much as you thought it was. This can cause you to not hold on to your stock for too long – in some cases until bankruptcy (something that yours truly has experienced firsthand).
I believe that the single most significant predictor of outperformance – what separates the best from the rest –Â is an investor’s ability and willingness to recognize one's own biases and act accordingly. When reading Mohnish Pabrai, Charlie Munger, Howard Marks, Nassim Taleb and maybe especially Bruce Berkowitz, one gets the notion that they attribute most of their success to this seemingly simple fact.
Why, then, don’t we all do it, if it is so simple?
The reason is that, while it might be simple, it is far from easy.
As a value investor, one of our foremost tasks is being willing to think in a contrarian manner and sticking to our guns when the market moves against us momentarily. However, the tricky part lies in recognizing when Mr. Market goes against us for reasons that are uncorrelated to fundamentals and when the underlying story of the company has actually changed.
Remember; the market is fairly efficient most of the time.
In today’s financial world, there is a never-ending stream of quotes, news and other noise, which can drive any rational investor to the brink of sanity.
If you buy the premise that most of us suffer from confirmatory bias, then it might be worth exploring a few ideas that can help circumvent that bias.
- Kill the thesis: Bruce Berkowitz (Trades, Portfolio) employs this concept, in its purest form. After having constructed an investment thesis about a given company and made sure there is sufficient margin of safety, he will gather as much negative information about the company as possible. If none of the stories are enough to kill the company, then he will invest. In order to make sure the story doesn’t change down the road, this is worth doing every 6-12 months.
- Separate yourself from the newsflow: An idea employed by Nassim Taleb and expounded upon in “Fooled By Randomness” where he argues that too much noise will crowd out any real information about a given company, and therefore it makes sense to not pay attention to the newsflow. In addition, I believe this is part of what Munger talks about as well, when he argues that practicing “assiduity” is what has gotten him and Buffett where they are today.
- Don’t get married to a given company: As I argued above it is hard to change your mind once you’ve already made it up. This happens in spite of clear evidence to the contrary. Think about a teacher unwilling to give credit to a student who has improved. It happens all the time. And it happens to the nth degree in the investment world. If you want outperformance you need to take a good, hard look at the facts every so often. And if indeed the facts have changed, then your mind must also change.
- If in doubt inaction is the best action: A lot of the time conflicting information will be presented. Indeed this is what makes this game so incredibly fascinating –Â the ability to generate differences of opinion even between highly skilled professionals. However, one cannot change one’s mind at every turn and at every new piece of information presented; therefore it is advisable sometimes to do nothing and wait until one can collect better information.
Because of the need to think in a contrarian manner, the problems presented here compound. Because not only do we want to go against groupthink that we encounter when we can profit from it, we also want to change our minds when the group is right, and there is actually something to the story. Indeed our thinking must be independent of the herd, and we must continuously draw our own conclusions based on the facts presented. This, of course, is a task that is much easier said than done, which is part of the reason why so few investors outperform the market over a long period of time.
The key takeaways from this discussion are as follows:
- Recognize that as a human being you are hardwired to display biases – even more so in investing.
- Change your mind when the facts do.
- Don’t get sucked in to paying attention to the daily flow of news – if it is important enough it will reach you.
- Sometimes inaction is the best action.
- Think independently – digest the information yourself.
If you have any questions, or input to the discussion I would love to hear from you.
All the best,
Nick
