Beware Confirmation Bias

Now there's an exciting title for you, eh? "Beware Confirmation Bias." I might as well entitle the darn thing "Please Don't Read This" or "Tantalizing Developments in Swedish Poultry Inventory Cataloging."

But confirmation bias and its cousin, negative confirmation bias, are two dangerous components to investing. Confirmation bias is the investing equivalent of a full house in poker -- you've got a great hand and you're convinced that you're going to win. But someone at the table keeps raising your bets. "Sucker," you think. "I'm going to make this expensive for you." Ah, but come time for the showdown, you're in for a shock. You lose -- to a higher full house.

Confirmation bias is the human tendency to focus on news that confirms our biases, and ignore or reject any information that puts it into question. In the example above, you had great cards, and you focused on those cards and the eventual positive payoff. At no point did you consider that your opponent's analysis, which went counter to your own interests, was somehow correct. Had you even thought about why your opponent might be acting rationally, you could have avoided big losses. But the reality of the situation was going to play itself out regardless -- you were going to lose.

I suspect that I'm going to hear from plenty of poker purists who wish to discuss the rationality of playing with inferior cards. Stipulated -- it's not a perfect analogy. In poker, you can overcome situations with a negative potential outcome through your betting. You can convince opponents that you have more than you do. But this is hard to do -- as in the above example -- if you fail to consider what your opponent holds. A lot of money gets lost this way. You may win some big hands, but the overall expectation of returns for playing this way must be negative.

Unlike poker, where there is a defined beginning and end to each hand, investing is dynamic -- the process doesn't end. That's the problem with investing -- you can be making very, very dumb money decisions and still generate positive returns for a long time. No wonder people tend to be confused about what drivers make for wealth-building investments.

If you spend any time on Internet message boards for individual companies, you'll find some real, base misunderstanding among people about what outcomes are necessary for their investing theses to be correct, if they have theses in the first place. Many of these folks will savage anyone -- journalist, analyst, fund manager, or fellow individual investor -- who voices a negative opinion of their company. And by and large the denizens of the discussion board eat it up -- especially when there are external reinforcements to the gang mentality evinced on many stock message boards.

For example, earlier this year, following the release of Erbitux, ImClone (Nasdaq: IMCL  ) stock roughly doubled in the course of two months, hitting an eventual peak in July at about $87 per share. Several pundits voiced an opinion at the time that the assumptions baked into these prices were at best wildly optimistic. My colleague Charly Travers, a real, live biotechnology expert with no particular axe to grind, was one who voiced his skepticism when the stock traded at $66 in April.

But the stock price kept rising, which somehow "proved" that those negative on the stock's potential were completely wrong. The response to Travers' article was brutal, with folks demanding to know "who he worked for," calling on the company to issue "a PR" to respond, and so on -- as if a response, or some sort of confirming news would wipe away the risks that Travers identified. A glance at ImClone's message board on Yahoo! (Nasdaq: YHOO  ) from that time shows something else -- the denizens immediately glommed onto a Bank of America (NYSE: BAC  ) analyst report that put the company's value at well above the price at the moment. Rationale: Bank of America agrees with us, so we like Bank of America. The Motley Fool does not, so they are idiots. This worked... until it didn't. In September, ImClone released disappointing sales results -- something for which those who trashed the naysayers were completely unprepared.

The trouble is that neither position allows the investor to spend any time at all thinking about the issues that are raised. It is not enough to say that those negative about the company might be right, for as we know, many times they are not, or have dramatically overstated the risks. Everyone is guilty of this from time to time, I did so last year when I believed that the risks facing Elan (NYSE: ELN  ) had the potential to put the company into bankruptcy. But just in the same way that risks can be overstated, so can opportunities. Travers took it on the nose for months as ImClone climbed higher, but that's not a horribly relevant data point. Traders taking an overpriced stock higher isn't a justification, it's a rationalization, nothing more.

But the folks who got together and talked all day about ImClone on the boards ate up the BofA analysis -- the rapidly rising stock price made them feel like geniuses at the moment that they needed to be most cautious. For stock prices that are not confirmed by rising fundamental improvements will not stand. And that's why confirmation biases can be so damaging to one's portfolio. If you discount every single piece of negative information or opinion, how in the world are you going to recognize a true threat?

Instead of providing forums where companies can be rationally discussed, many message boards offer instead a place where speculators can hoist themselves on their own petard. When stock prices rise, they come together and feel very, very smart (another mental bias -- this one overvaluing recent events versus ones that happened long ago, even if the recent ones are of little substantive importance). When negative information comes out, they either rationalize it away or build up mutual confidence by savaging the source. They have confused their familiarity, their consumption of all information that reinforces their point of view, with knowledge, when in reality it is quite the opposite. It's the worst kind of opposite, too: not knowing -- and not caring to know -- what you don't know. Too often I receive emails from people stating that "the longs" disagree with me about the prospects of some overpriced moonshot like Travelzoo (Nasdaq: TZOO  ) . I am, of course, happy to entertain disagreements, and as the Elan example above proves, I have no delusion of infallibility. But the simple act of a group of investors circling the wagons against a voiced risk doesn't eliminate the risk -- it doesn't even respond to the voice. It simply establishes the power of groupthink to ignore an issue, whether it turns out to be substantive or not.

The trouble with the overconfident is that they by definition will ignore warning signs and risks. So long as a risk doesn't become reality, it wasn't ever real, right? And the reality in investing is that some people get away with it. For every total meltdown like CMGi (Nasdaq: CMGI  ) , there is a company that simply defies every risk element that it faces. Yahoo! comes to mind, as does eBay (Nasdaq: EBAY  ) .

Investing is all about risk capital -- perfect information doesn't exist. Just the same, successful investing does take some cues from successful gambling. I quoted famous poker player "Puggy" Pearson in April, and I do so again: "Ain't only three things to gambling: knowing the 60-40 end of the proposition, money management, and knowing yourself. Even a donkey knows that."

Those who fail to combat their own biases by avoiding negative information will have an awfully hard time with any one of these three elements. They can't figure out the risks, they can't manage their money to appropriately address the risk of being wrong, and they probably aren't introspective enough to see that their own cognitive biases are putting them at enormous risk.

Bill Mann's own cognitive biases include grandeur, sophistication, and literacy. He owns none of the companies mentioned in this article.


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