Avoiding the Pitfalls of Confirmation Bias

By Jason Fitnich

Tom has written in the Forum and in past Coaches about the Value Investing Royalty, a cadre of value investors whose prowess and notoriety are ubiquitous on the web, in blogs and all over the media. Their performance history, their position-building methods and their usual willingness to share their opinions on stocks have informed the choices of many investors.

These guys are well-known for a reason, and following the moves of shrewd investors would seem to be a suitable way to find stocks and companies for one’s portfolio. However, in our search for ideas, we need to beware of confirmation bias.

Confirmation bias is the tendency to seek out only information that confirms our current thinking, disregarding or avoiding any information that does not. As part of the investment process, confirmation bias can creep into our decision-making abilities and cloud our judgment.

It’s easy to see how this happens. After spending time determining whether a company and its stock represent a value, what amateur investor wouldn’t feel a certain pride learning that a member of the Royalty and their team of analysts spent the last quarter building a massive position on the same stock? What a confirmation! You’re playing like the big boys now.

I admit it. I too have become intoxicated by confirmation bias. To help you avoid the resultant hangover, let me use a personal example.

Working in the banking industry, I’ve followed Tom Brown’s career for many years, first as a banking analyst and then as the founder and contributor to Bankstocks.com. Brown is as savvy as they come when dealing with financial services companies, and in 2006 he identified First Marblehead Corp (FMD) as a company with high prospects.

FMD’s business advised large banks like Bank of America Corporation (BAC) and JP Morgan Chase (JPM) on structuring asset-backed securities (ABS) offerings for student loans. Using a proprietary database to discern performance and default rates for millions of dollars of student loans, FMD reaped huge upfront fees and took no credit risk on the deals.

Despite such performance, at least two analysts from Wall Street firms disliked the stock. Over several months, Brown chipped away at the opinion of those analysts while the stock went up.

Around the same time, Bill Mann of The Motley Fool made FMD a formal recommendation in the Fool’s Hidden Gems newsletter. Incidentally, Mann introduced me to Brookfield Asset Management (BAM) back in 2005, and his great nose for value makes him one of the sharpest investors around.

So, let’s set the stage:

• Read FMD’s annual report and their 10-Qs and followed past deal performance? Check
• Respected hedge fund manager Tom Brown likes the stock? Check
• Respected Hidden Gems contributor Bill Mann likes the stock? Check
• Stock has been going up? Check
• Wall Street analysts have been discredited and are licking wounds in a corner somewhere wondering why Tom Brown keeps urinating in their bowl of cornflakes? Check

I did not see it then—probably because confirmation bias was clouding my vision. Blinded to the bear stance on FMD, the negatives were all in my periphery and could not possibly come true. Heck, if I couldn’t trust Tom Brown, who could I trust? Myself? He was telling me I was right, so how could I not believe that?

For the nightmare end to the story, look at any 3–5 year chart. The ABS market cracked along with FMD’s business model. Without their database, the company’s ability to convince ABS buyers to take out money upfront—that is, to complete deals—dried up along with its profits. The stock price fell sharply.

The moral here is simple: As an investor, you need to know why you own the stock, not why someone else does. To hold the stock through difficult markets, you must believe in its future prospects. Whether other investors are building or decreasing their positions should have little—if any—bearing on your decision to hold or sell.

Remain agnostic in your information gathering. Excellent investors have investment processes that generate more winners than losers over time. Compare their ideas with your own investing process and appetite for risk. Above all, know what factors would change your investment decision. Don’t be afraid to search out the bear case and ask yourself if it is credible.

By doing these things, you won’t be scared out of a winning investment when someone’s hedge fund blows up and the Value Royalty is blowing out the stock for non-fundamental reasons. You’ll also stand a better chance of avoiding confirmation bias when Mr. Market is about to deliver a smack to your portfolio value.

By the way, neither Tom Brown nor Bill Mann is to blame for me losing money in FMD. My finger clicked the buy button for each trade and my confirmation bias caused the capital losses on my tax return. An expensive lesson—one I hope that I will not need to learn again, and that you might avoid completely.

Disclosure: The author owns no current positions in stocks mentioned here. He does own positions in all stocks held in the CGI Growth & Value Focus Growth Portfolio, which he manages and is his real money.

Comments

[enigmaman:]

Seems to me you cannot trust the fundamental approach because its all biased, the company telling you why they are as good as they are even when they are not, then you have the big analysis company following the corp every move who explains why the negative you think you see isnt what you think it is, and not at all negative, then you have the other financial companies come in behind the first few jumping on the band wagon, cheering the numbers reported, then you have CNBC chiming in as well finding green shoots all over the place and then you have little old main street investor who isnt sure, nervous but then says, who am I to fight those who know more then I, that have direct access to the corp any and all info, have the best financial minds doing their own research and issuing their own reports and charts, little old main street investor working with Fidelity doing his own research and to expect him to come up with the true story seem a bit presumptive, except if he also an expert in forensic accounting. Sounds like your asking way to much of main street, after all most on Wall Street with all their financial and accounting degrees, years of experience and hot line to the boss, most of them got it wrong. So while I agree with the articles premise it seems impossible to attain

Oct 19 02:46 PM

[Angel Martin:]

Since I believe that we are at the start of a strongly growing economy and disinflationary financial assets boom, I avoid confirmation bias by clicking on just about any article on Seeking Alpha!

Oct 19 06:12 PM

[glendokid:]

Enigmaman,

I voted FOR your comment even though I don't agree with it's conclusion because you said a whole lot of things with which I agree and can't believe more individual investors don't know.

The premise of the CGI article was that we all have to be careful of confirmation bias. It's a great point. If you haven't done it, I suspect you haven't bought a lot of stocks on your own judgement.

However, it has a huge flaw in that you only catch yourself when you lose! What about all the times you got a winner - did you look to see if your hypothesis was wrong but you got lucky?

Your point - that if you want to beat the market you have to beat all of the analysts and Wall Street (think about all the smart folks at GS!) and the CGI stock pickers, isn't that going to be hard? IS A WONDERFUL POINT.

If you don't have a good answer to this question, my advice is:

1: Don't feel bad. There are lots of very smart folks in that club.
2. go to Lazy portfolios. They beat the vast majority of "professional" stock investors (read: Mutual Fund Managers)

Good luck hunting for the answer.


On Oct 19 02:46 PM enigmaman wrote:

> Seems to me you cannot trust the fundamental approach because its
> all biased, the company telling you why they are as good as they
> are even when they are not, then you have the big analysis company
> following the corp every move who explains why the negative you think
> you see isnt what you think it is, and not at all negative, then
> you have the other financial companies come in behind the first few
> jumping on the band wagon, cheering the numbers reported, then you
> have CNBC chiming in as well finding green shoots all over the place
> and then you have little old main street investor who isnt sure,
> nervous but then says, who am I to fight those who know more then
> I, that have direct access to the corp any and all info, have the
> best financial minds doing their own research and issuing their own
> reports and charts, little old main street investor working with
> Fidelity doing his own research and to expect him to come up with
> the true story seem a bit presumptive, except if he also an expert
> in forensic accounting. Sounds like your asking way to much of main
> street, after all most on Wall Street with all their financial and
> accounting degrees, years of experience and hot line to the boss,
> most of them got it wrong. So while I agree with the articles premise
> it seems impossible to attain

Oct 20 07:29 PM

[captainccs:]

The article implies that First Marblehead crashed on its own, that it had nothing to do with the general financial meltdown. While FMC did do a couple of dumb things, neither of them can take credit for the meltdown.

OK, beware confirmation bias. Now give me a real example.

Oct 26 08:04 AM