Friday, June 26, 2009

About Confirmation Bias in the Stock Market

What is confirmation bias? It is a cognitive bias that makes us look for information that confirms our theory or belief while ignoring anything that contradicts such belief.

This is an area of behavioural science that is of particular importance in the field of research science; such a bias should not cloud critical thinking when doing experiments.

Scientific research papers go through a process of vetting at different levels by guides, peers, publishers before seeing the light of day. Any cognitive bias involved in the design or measurement of experiments are quickly detected.

A similar process is sadly lacking in the field of stock research. The other day, four research reports about a particular company landed in my inbox. Two of them recommended a 'buy'. One a 'hold' and another, a 'sell'. All four reports had pages of charts, figures and convincing arguments to back their respective recommendations.

The interesting thing to note is that only one out of the four gave a 'sell' recommendation. Why interesting? Because a 'buy' or a 'hold' call is much easier for the human mind to accept. It confirms that we were 'right' in choosing the stock.

A 'sell' call has negative connotations. It means admitting that we made a 'wrong' decision. It lowers our self-esteem in our own eyes. How could we have been so stupid? Why didn't we see through this crooked management or poor financials earlier?

Confirmation bias is a regular occurrence at some of the investment groups. Some one with credibility recommends a stock as a 'value buy'. Others join the bandwagon blindly. If any one voices a contrary opinion, research reports giving 'buy' calls start flying around. The logic is: 'Who cares about fundamentals? See how the stock is moving up!' Works fine in a bull market. The bear market is already history, isn't it?

Investors must develop critical thinking skills to overcome confirmation bias. Before choosing a stock, proper fundamental analysis should be undertaken. That includes writing down reasons for buying as well as reasons for not buying. Give points for each decision in an unbiased manner. Then decide which side the scales are tilting.

Related post

How to pick Stocks for Investment - Part III


Rishi said...

How true, i have experienced this in my little journey so far in many stocks. I would like to put my experience wrt Bartronics. When the market was at its best, there were buy reports all around pointing out how the company is a good one to buy, how revenue is coming in via many projects, but no one talked about -ve cash flow from operations. From the reports i was convinced i should buy the company for their product [luckily i postponed buying, looking for a price correction]. Later during the bear market there were reports of sell and talks about the sudden rapid growth in few years, how fundamentals didn't support those growth, how revenues would get delayed from government projects. This influenced my decision not to buy the stock. Hindsight my outcome was biased based on the reports, rather than researching the company on my own to understand the company and financial.
Later your blog about Bartronics helped me understand what i need to look in a company before taking a call to invest. To aid more, your other blogs esp ones related to how to select stocks, is helping me forming a strategy.
Do you think sticking to one' own strategy will lead to cognitive bias towards the same?

Subhankar said...

Great question, Rishi.

I'll have to be honest and answer in the affirmative. I've often missed good investment opportunities because of rigidly sticking to my strategy.

In stock investments, you need not be 'right' all the time. As long as your 'right' decisions make you more money than you lose making 'wrong' decisions.

That is what makes investing in the stock market a continuous challenge. You must have a strategy to succeed. But you also have to be flexible and need to keep an open mind.

Unknown said...

After making several mistakes in my investments, I can say this:

* When you are jumping into a stock because somebody said so, you are typically looking for a price rise, which may or may not have anything to do with fundamentals. Treat it as a trading stock with strict stop loss and chances are (IF you do not let your greed overtake you), you won't be disappointed.

* Personally, I do not subscribe to the idea of selling a stock to pick it up 20-30% lower. Frequent churning is a trader's game. But, this is what (unfortunately) most people do in the name of investing and reducing the cost. (Should this have been in the comments section of "Buy and Hold"? :-))

* Confirmation bias is a real threat - as I found out in the bear market. Ignoring signs of things turning for the worse, the mind likes to play games and stresses the importance of price more and more.

a) After all, when your stock goes up 3-5% every day, you are sitting on a winner and at this speed, you would double your money in the next month. Then, why sell?

b) Ignore the bad news. The management knows how to fix things. May be this bear cartel wants to pick this stock at lower levels, so they are spreading bad news around.

Alas! Market reminds time and time again, that over the longer time frame, value matters, not the short-term euphoric price movements.

Subhankar said...

Thanks for sharing, Eswar.

You can be a little slipshod in a bull market and get away with it. But in a bear market, you need to be vigilant and disciplined. If you've made a mistake, be ruthless with yourself and get out.

Setting reasonable stop losses is one way to stop a small loss from becoming a devastating one.