Thursday, February 5, 2015

Psychology of Markets - Confirmation Biases

In our first Psychology of Markets post last week, we briefly touched on the extreme bearishness in early 2009 that ultimately kept us from participating in the market's initial bounce off the lows.  Given that we'd become married to our bearish thesis, we went in search of data and commentary that fit our narrative.  By reaching our conclusion first and then going in search of facts that supported it, we were guilty of operating with a confirmation bias.  While we certainly weren't the only one's operating with this mindset during the 2008-2009 crash, it prevented us from capitalizing on the market's rally off the March bottom.

Confirmation biases are definitely not unique to just investing.  They show themselves in all facets of life on a daily basis.  In the age of 24-hour news channels (politics, investing, pop culture, etc) and events landing on social media within seconds of their occurrence, operating with a confirmation bias is big business these days (and on a simpler level, perhaps just the accepted status quo for many).  Certain individuals and corporations have made piles of money and gained celebrity status by catering to the biases of the masses.

When we look at the investing landscape as it is today, we see the risk for investors to succumb to a confirmation bias to be as high as ever.  In 2011, did many convince themselves that gold and precious metals had years to run? Yep.  In 2012, a great many continued to buy Apple into the $700s as they shouted from rooftops that it was headed to $1,000/share and beyond.  Its share price was halved in just over six months.  And just last year we saw most pros insisting that the end of the bond bull market was upon us and had positioned themselves accordingly.  In each of these situations it appeared that people had put the proverbial cart before the horse and allowed their desired/predicted outcome to dictate how they gathered and interpreted data.  This is nothing new in practice and has gone on since the advent of speculation.

However, what's changed is the speed.  We can now satisfy our confirmation biases and need for reassurance within seconds.  With Twitter and Google and real time news flow, we are able to satisfy our need to be proven "right" almost instantaneously.  While advances in technology have given just about anyone with internet access the chance to manage their own money, they have also given investors plenty of excuses to be lazy and not perform proper due diligence.  Any jackass with a Twitter handle can shoot off tweet after tweet about why XYZ is headed to the moon.  Unfortunately, there will always be those tortured souls who are waiting, and even seeking, to have their confirmation bias fed.  Ultimately, Mr. Jackass on Twitter gets linked up with Mr. Tortured Soul and the recipe for disaster is complete.  This happens every day that the market is open for business.

As you work to build and maintain an investment process (even if that just means selecting an investment advisor) make sure that you've taken an inventory of your biases and revisit them on a consistent basis.  It's really easy to allow desired outcomes to interfere with your day-to-day analysis of the actual facts.  This message cannot be emphasized enough in the context of the current market.  It's absolutely necessary to keep an open mind about potential outcomes as we work through these high volatility, high chop days.

Have a great Friday.

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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