See, if you don’t know what confirmation bias is, you might be making all sorts of little mistakes without even knowing it.
I think the image to the left from psychlopedia encapsulates the concept quite well.
It’s basically this idea that we always go into things with our own set of beliefs and perceptions already set. When that happens, we can all too easily cherry pick out all the information that supports our idea and ignore all of the contradictory evidence.
When it comes to trading and investing in stocks, this represents a real problem. So much so, that even Warren Buffett, counts confirmation bias as one of the biggest problems for investors. This is what he had to say on the matter:
“Charles Darwin used to say that whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants. Man’s natural inclination is to cling to his beliefs, particularly if they are reinforced by recent experience–a flaw in our makeup that bears on what happens during secular bull markets and extended periods of stagnation.”
Confirmation bias in stocks
I doubt there is any trader who goes into researching a stock without some pre-conceived idea about it. If the stock is up 50% already this year, it’s hard not to think that this must be a fantastic company. And if the stock is down 50%, it’s hard not to think that this company could face even harder times, such as bankruptcy.
Likewise, if a stock jumps 10% in just a few minutes, it’s tempting to jump straight in, reckoning that the stock will probably keep going higher and higher. After all, there must be some fundamental reason why the stock is moving so quickly, right?
When it come to trend following and momentum strategies, the common belief is that all you need to do is to buy stocks that are going up and sell them when they start going down.
Of course, the beauty of back-testing strategies is that you can test these perceptions and see if they stack up in reality.
And the truth is, if all you do is buy a stock when it makes a new high and sell it when it makes a new low, you’re not going to do all that well.
To prove this, I took a simple strategy where you buy on a new 20-day high and you sell (close the trade) on a new 20-day low. I applied this simple approach individually to every stock in the S&P 100 universe between 2000 and 2015.
If you look closely at the chart below you’ll see the compounded annual return trading this strategy for each individual stock in the universe. Over 80% of stocks in the universe produced a compounded annual return of less than 5% using this strategy, over the 15 years.
It’s plain to see that there is more to following trends on stocks than just buying new highs. Success comes from the small details; from portfolio management, from risk, and optimal timeframes.
But aside from price moves, there are more subtle, everyday reasons why you might favour a certain stock.
Maybe you read a positive write up about the company a couple of weeks ago, maybe the stock turned up in one of your stock screens, maybe you heard someone in the cafe saying it was a good buy, or maybe you simply know the ticker symbol of the stock in question but you can’t actually remember why.
Whatever it is, we all start off with a pre-conceived belief of the stock in question. For example:
Apple… a super-stock, perhaps too expensive right now…
Coca-Cola… a classic performer, the kind Warren Buffett likes to buy…
Tesla… Massive growth ahead, but speculative and risky…
These are the sorts of beliefs that occur before you even start to do any research. And this extends to sectors as well:
Resource stocks… risky and speculative
Utility stocks… defensive and reliable.
The truth of course, is that all companies are different. And any stock, at the right price and time, can be a good buy. As such, a beaten-up utility stock, undergoing huge changes in it’s business model, might easily trounce a small-cap technology company that is expanding too quickly.
It was all for nothing
Another reason why confirmation bias is so prevalent in stock investing, I think, is because stock investing is so time-consuming. Consider the analyst who spends many hours researching a particular company. She looks at balance sheets, reads reports, checks cash flow statements, updates spreadsheets, even interviews directors of the company.
It’s only reasonable to expect that after such diligent research the analyst will have encountered some level of bias for the company. She doesn’t want all those hours of work to have been for nothing and so she writes up a detailed report, slaps a ‘buy’ rating on the stock and sets a price target 30% away from the current market price.
Not all analysts are like this of course. But it is easy to see the problem. As soon as you have a vested interest in something, or as soon as you’ve spent a lot of time on a thing, the bias will be there. After all that hard work, you don’t want to simply forget about the stock and go through the same drawn out process all over again.
How to overcome confirmation bias
There isn’t an easy way to overcome confirmation bias so the key is to recognise that it’s there and act accordingly. Instead of looking for reasons why you should buy the stock, look for evidence why you should steer clear.
Warren Buffett likes to challenge his confirmation bias by seeking out those with different opinions. If he finds any reason at all that could cause the stock to suffer a big loss, then he simply moves on to another idea.
Meanwhile Bruce Berkowitz deals with it by trying to ‘kill the company‘:
“…We try to kill the company. We think of all the ways the company can die, whether it’s stupid management or overleveraged balance sheets. If we can’t figure out a way to kill the company, and its generating good cash even in difficult times, then you have the beginning of a good investment.”
Using strict rules
The problem is that even the most disciplined system traders still succumb to confirmation bias now and again, either when building a strategy or when skipping signals.
So make sure you’re aware of confirmation bias and do your best to fight against it. Perhaps take a course on statistics or data analysis. Do whatever you can, to make your trading scientific and judgement free.
Thank you for reading.
Analysis in this article was created with stock data from Norgate Premium Data, tests performed with Amibroker.