Could The Biggest Risk Be Confirmation Bias? - Weekly Blog # 564

by: Mike Lipper, CFA
Summary

Have we entered a phase that will lead to substantial losses and mixed opportunities?

This comes back to my perennial question of why so many bright professional and other investors wind up with substantial losses and missed opportunities.

I have posed the question of whether there is some malfunctioning in our investment brains to Caltech professors studying neuro-economics.

The best answer I have heard is that judgement is derived by comparing inputs with past memories. Apparently, when we are presented with a new element we compare it to past elements.

If it matches closely to what is in our memory, we see it as confirming our views from the past, reassuring us as to the correctness of that view. This process is labeled confirmation bias.

Have we entered a phase that will lead to substantial losses and mixed opportunities? This comes back to my perennial question of why so many bright professional and other investors wind up with substantial losses and missed opportunities. I have posed the question of whether there is some malfunctioning in our investment brains to Caltech professors studying neuro-economics. The best answer I have heard is that judgement is derived by comparing inputs with past memories. Apparently, when we are presented with a new element we compare it to past elements. If it matches closely to what is in our memory, we see it as confirming our views from the past, reassuring us as to the correctness of that view. This process is labeled confirmation bias.

Earning Recession Confirmation Bias at Work?

Arbor Research & Trading, utilizing data published in The Wall Street Journal from Bloomberg, displayed the frequency of forecasting an "earning recession" by various T.V. business news channels. It showed that the forecast was much more prevalent on CNBC than Bloomberg and was not mentioned materially by Fox Business. One suspects that those who tend to support Democrats largely view their business news through CNBC, with perhaps some clarification from Bloomberg. Others, often with more money to invest, get more of their news and views from Fox Business. Each camp goes to their likely source for conformation of their views.

"Contradictory Data Confound Economists"

This was the headline in a Wall Street Journal (WSJ) weekend edition article. Economists that either work for the government or academia tend to focus on time series captured by long-term government workers. Marketers and investors tend to be more comfortable with data that is accessed through the private sector. In an over-simplification, data supplied through government sources is currently showing signs of deceleration in the US economy, whereas commercially produced data continues to see an expansion. Is Confirmation Bias at work?

Stock Market Data Shows Continuing Recovery And Faith In The Future

Every weekend the WSJ compares the last reading of the week with that from a year ago, for the Dow Jones Industrial Average (DJIA), Standard & Poor's 500 (S&P) and the Nasdaq Composite (Nasdaq). The price recovery for the indices, measured against their all-time highs established in August through October of 2018, continues. The DJIA is only down -3.65%, the S&P 500 down -5.48% and the Nasdaq -8.52%.

Looking at these declines from peak levels, one might be surprised to learn that for the latest 12 months and the next 12 months, the Nasdaq has the highest P/E valuation and the DJIA the lowest, which is the opposite of their performance rank.

In a gross simplification, this suggests that the future is perceived as being better for the Nasdaq and its technology/growth-oriented stocks than the industrial and consumer-focused DJIA. This opinion is buttressed by the current market performance of diversified equity funds. The S&P 500 has more growth than the DJIA and has a lower industrial weighting.

For the calendar year through last Thursday afternoon, 61% of US diversified equity fund averages gained more than the low-cost, fully invested, S&P 500 Index fund average. Active managers, despite the handicap of higher expenses and the burden of cash, were selecting equities that were more attractively priced than the S&P 500.

The Untold Story About Dividends And Their Price Value

The yields on the three indices are 2.3% for the DJIA, 2.0% for the S&P 500 and 1.09% for the Nasdaq. While the yield numbers are small relative to earnings and market movements, they play a real role in declining markets and may well be one of the reasons the DJIA has declined less than the S&P 500. The key is the growth rate of dividend payments. For example, in our private financial services fund, we hold shares in Moody's. This week the company raised its dividend by 14% despite announcing cyclically declining earnings.

They have a history of raising dividends each year. While the current yield is below 2%, the yield at our cost is over 10%. Even though the stock has risen 8x its original cost, the tax impact is a multiple of the dividend. As it would be one of the last positions sold for the more senior holders, there is a reluctance to sell before other positions are liquidated.

It is my impression that tax-paying investors in stocks in both the DJIA and S&P have held some of their holdings longer than many investors in Nasdaq stocks, so they probably turnover their portfolio at a slower rate. Thus, in down markets, there is a slight tendency for the more senior holdings to fall less than the newer ones. This in turn may reduce their daily volatility.

How To Reduce Confirmation Bias?

While there is no perfect person except your special person, mere mortals have weaknesses, including the inability to totally research problems completely. Divide inputs between those that have a good record of success and those that are more wrong than right. Both should be listened to and studied. Recognize that it is exceedingly rare for people and their actions to be correct more than 2/3rds of the time and certainly any record of 75% should be disbelieved.

But also pay attention to negative indicators, they may be correct 1/3rd of the time and quite possibly at least 10% of the time. These ratios are point of time-oriented, whereas many of our decisions deal with a continuing process, such as dollar cost averaging, building a position in an important investment or deleveraging a portfolio. During such a process, one can change the rate of engagement, pause it, or even temporarily reverse direction. The key is to be correct on balance with your money, not just with the number of right vs. wrong decisions. And most importantly, to learn about your own process, particularly when mistakes are made.

Questions of the week:

What have you learned about your confirmation bias?

What have you learned about investing in 2017-2018?

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.