How Confirmation Bias Can Sink Your Portfolio

Summary

• Technical Analysis trumps 'gut feeling'

Ego plays a large role in financial decisions. Just like any other business, investors and traders need a healthy ego to survive the inevitable losses that transpire. By healthy, I mean that person demonstrates that they share in the rewards that follow or honor those who helped them achieve success. We all have an ego- I believe it’s necessary to be successful in any business undertaking. But even with a healthy ego comes the risk of confirmation bias.

We definitely do this politically, don’t we? A great resource is the ad fontes media bias chart. We lean left or right, and read or watch those media outlets that match our own bias. It’s no different in the financial press. You’re long gold? You watch Kitco News, read ZeroHedge, etc. I freely admit I have a bias towards precious metals right now, but I temper that bias when it comes to trading or investing. On one hand we have the Fed ‘goosing’ the market and suppressing interest rates- how can that not be bullish for stocks and gold? If you are naturally biased in that direction, there is a ton of confirmation bias to be harvested as these media outlets provide you with a never ending torrent of experts who confirm what you already believe. Without the cold, hard truth called price, however, we might ultimately become victims to this bias.

The recent move in gold we’ve been tracking in my blog at Wilson Speculations is worth examining. I remained bullish in my non-leveraged positions while we went through what appeared to be some sort of sideways pennant/flag pattern of some kind. It would be easy, even in light of technical analysis, to remain bullish after a big run up and a sideways consolidation. Typical, right? When examined in more detail, I made the observation that the first leg down in the consolidation was out of whack with the rest of the proposed triangle pattern. This usually suggests that the triangle may actually be on a smaller scale and implies that the consolidation is a pause before resuming the direction of the first wave down, and that’s what we got.

Does that mean that my core positioning is irrevocably changed? No, but I can take steps to protect myself (go to cash, hedge, etc) until I see evidence that market behavior has changed. It’s this function- the re-entry- that financial advisors warn their clients about, and rightfully so, I think. Most people do not have the right skills or mental approach to manage this kind of endeavor. I get out of stocks because I see something I don’t like, and that’s fine, but the amateur sees 3 or 4 days of gains and they worry that the market is taking off without their participation. Then wham!, the takedown happens.

I’ve mentioned my old friend and mentor Samir many times in the blog and in my e-book. Samir believed in different things than I did. He was a socialist and an atheist, where I firmly stand on the other side of those views. On the atheism front, he was right about one thing. You really need to have zero religion when it comes to your investments, or they will own you. Being stuck owning stocks in a severe market downturn is not a pleasant scenario for those of us who are fortunate enough to have something to protect. For a financial ‘pro’, getting caught wrong footed in a market downturn can be hazardous to your portfolio and your health. To this end, it’s worth noting that the hedge fund industry has basically become an enormous long/short fund. Wealthy investors pay 20/2 for the benefit of making 2-4% a year. In 2019, the industry had a ‘windfall’ of 6%. They have collectively decided not to pick winners any more, eliminating bias, and instead have adopted the bookie/casino business model, where the house earns money at the margins.

You could do this as well, I guess. Take your ball and go home, and invest in long/short funds. From my perspective, that is not only boring, it also lacks foresight. After fees, that doesn’t leave a whole lot of profits for investors. If you can learn the discipline of dispassionately following price in the form of technical analysis, I think it’s quite likely you can profit and protect at the same time. It’s not easy, but it’s profitable.