Mental Models: Confirmation Bias

Two weeks ago I started the series My First Years of Investing in which I share my experiences and beginner mistakes. You can read the first article here, and the link to the second article is here. Before I dig into my motivation to start buying stocks of dividend growth companies, which will be the third part of this series, I wanted to elaborate more on the mental model of confirmation bias. The reason for this is that it has played a significant role in my decisions to buy, hold or sell a stock during my first years of investing. Those days haven’t been particularly successful. To say the least. At the same time I don’t really feel I bottomed this one out yet. I don’t control this recurring bias yet, it owns me. There’s still enough to reflect on in order to get a better understanding of this instinctive reflex.

“Remember this: the pain is all in your head. If you want to evolve, you need to go where the problems and the pain are. By confronting the pain, you will see more clearly the paradoxes and problems you face. Reflecting on them and resolving them will give you wisdom.”

– Ray Dalio

What’s This All About?

Confirmation bias is deeply rooted in our way of thinking and comes into play when we judge information on its relevance. It comes down to denying or rationalizing away the relevance, significance, or importance of opposing evidence and logical argument. Confirmation bias impacts how we gather information, but it also influences how we interpret it. We’re not mentally wired to have an open mind once we’ve taken a position on something, especially on emotionally significant issues. So, we all have our perspectives with its preconceived assumptions and unavoidable flaws which leads to biases. But the reason why confirmation bias has such a firm grasp on us is the elimination of a correction mechanism. It disconnects us with reality, or at least an opposing explanation of events or argumentation. The ground for critical thinking, doubt, suspicion and alternative views have been cut off. This is exactly the reason why confirmation bias will only get stronger with time and activity. I believe this works two ways. At one hand, confirmation bias make us to only select and order pleasing information that will be stored in our memory. You seem to be right so satisfaction guaranteed. I call this the one-time-event effect. There’s no reason to change our mode of reasoning. At the other hand, the confirmation bias is fed every time it processes affirmative information. Its base gets stronger, severe and more absolute. It has become a little bit harder to overcome. You could call this the stacking effect.

As confirmation bias has grown in magnitude with time and activity I believe it can only be broken by an event with an undeniable and painful impact. The reason for this is that under the usual circumstances of confirmation bias, the unpleasant new information can easily be ignored, denied or rationalized. Just like we always did. So, more is needed to open our eyes. That’s what they call a paradigm shift.

“This old truth is coming to an end.”

– Friedrich Nietzsche

Sorry, But What Does This Have To Do With Investing?

An important principle of value investing is you can’t time the market. Time in the market is better than timing the market. No one knows what the future holds. So we can’t tell whether we’re buying at the bottom. The advice to buy low and sell high is meaningless in this regard. We are only able to conclude if we bought a stock at a low price in hindsight. However, in hindsight nearly every mistake seems unnecessary and every investment success looks smooth. So, you really have to focus on the underlying fundamentals to determine whether a stock is trading at a low price and compare that to the intrinsic value of the business.

What really fascinates me, is at what point do you start to be wrong? I used to look at stock prices and thought declines of 30-40% or more are indicative. It’s only now that I see this is the wrong perspective. If you would like to know if you’re right or wrong about a company, you shouldn’t look at trading prices. It’s the core fundamentals that matter. To determine whether you’re right or wrong about a business, you have to know the contraview, which is the short thesis and track whether the fundamentals deteriorated. Is the company on its way down? But I didn’t search or read that information when I started investing in magic formula stocks or small growth companies. I didn’t do it at all. Not once. The section about risks in a long thesis didn’t even get the attention it deserved. I can see now that I was only interested in the upside. That’s one of the reasons I lost some of my money. I was only looking for supporting analysis or facts for the long position. You can think of insider buys, investors adding to their position or even investment pitches of years ago. Most of the times I bought more stocks without studying the fundamentals and analyzing for negative trends. A recipe for disaster, that’s for sure. You can see how confirmation bias is into play here. It really impacts how we gather information and how we neglect crucial information. This was a fundamental flaw in my decision-making process.

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When the share price of a stock I owned, went south for a while I was inclined to say: “See, value investing is not easy, I’m just being contrarian, Mr. Market is depressive again.” I justified my position in a stock with multiple quotes of famous and succesful investors and (unconsciously) made sure that the price movement was a confirmation of my opinion. But if the stock price increased I witnessed the long thesis playing out beautifully, I told myself I outsmarted everyone, and thought “I OWN Mr. Market. 😎” I just assumed my thesis was right and the moment I stepped in was spot-on. So whether the price went up or down, I was just right. Period. This is how confirmation bias influenced my way of interpreting information. I was in search for confirmation at all costs. No matter what happened. I even clung to the tiniest details of another bad quarter report of a magic formula stock or the second share issuance by a micro cap stock in a very short period of time.

Another one. Stock ownership by hedge fund managers was always an important check box for me when I invested in magic formula stocks. I always considered it because these guys are undoubtedly smarter than I am and have more time to analyze industries, companies and valuation multiples than I have. I thought, let them do the analysis and I invest a bit of my money in the same companies. Just driving shotgun, baby… But, so many hedge fund managers, so many positions. I focused on a handful in the beginning like Warren Buffett, Joel Greenblatt, Seth Klarman and Mohnish Pabrai. Later on I was also impressed by the track records of Leon Cooperman, Kenneth Fisher, Bill Ackman, Howard Marks and Ray Dalio. There was always an investing guru invested in a stock which had my interest. And if a hedge fund manager sold a stock I owned, there was always another big boy initiating a position in the same quarter. So my long thesis was always confirmed by one or an other one. Hey, they see value in this company. Let’s hold it, don’t sell yet. But at a lower price the same stock could offer a margin of safety. If the trading price of my stock collapsed with 50% over time, but the hedge fund manager stepped in at that low price he had a nice margin of safety if he analyzed the intrinsic value was 50% higher. Let’s assume he was right and that gap closed. Well, in that case he would have made a nice 50% gain. But with that increase in stock price I would still be down with 25%. So, it’s nonsense to find safety in guru ownership, especially at a much lower price.

“What should separate investors from speculators, Graham argued, was not what they chose to buy but how they chose it. At one price, any security could be a speculation; at another (lower) price, it became an investment. And in the hands of different people, the same security even at the same price—could be either a speculation or an investment, depending on how well they understood it and how honestly they assessed their own limitations.”

– Jason Zweig

What To Do, What To Do?

To erdicate confirmation bias I have to confront it right in the beginning. Otherwise it has a real chance to grow. Therefor it’s absolutely necessary to read the long and short thesis and pay no small attention to the risks of the long thesis. It’s also essential to focus on the underlying fundamentals of the business. I must be aware of my tendency to price-orientation. Another one is, stop rationalizing price swings as we’re better at rationalizing than at being rational. And last, but not least, don’t line up behind investing gurus. They’re often wrong and betting against eachother.

I want to finish this post with a wonderful and simple line by Jana Vembunarayanan from his post Self Deception and Denial:

Refusing to look at unpleasant facts doen’t make them disappear. Bad news that is true is better than good news that is wrong.

I really hope this post has offered you something to think about. Please feel free to comment.

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