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Avoiding Confirmation Bias

As I have mentioned previously, one of the points of the 80-20 Portfolio is to incorporate some of the research of Behavioral Finance into an Investing Strategy. One of the behavioral traps we go through is something called Confirmation Bias. In short, this is when you look at facts that agree with your investing thesis as confirmation of that strategy. This is a slippery slope and one that we all fall into even if we are aware of it.

I first learned about this concept when reading Nassim Taleb's book The Black Swan. He called confirmation bias "naive empiricism". He said, "You take past instances that corroborate your theories and you treat them as evidence." Further he writes, "I am saying that a series of corroborative facts is not necessarily evidence. Seeing white swans does not confirm the nonexistence of black swans." He cites a study by P.C. Wason. In the experiment subjects were given a three number sequence of 2,4,6 and asked what rule would generate this sequence. "Their method of guessing was to produce other three-number sequences, to which the experimenter would respond "yes" or "no" depending on whether the new sequences were consistent with the rule. Once confident with their answers, the subjects would formulate the rule." The problem is that most people will say something like 8,10,12. And the answer would be yes. After a couple of confirming examples you would announce that the rule was add 2 to the number before it, in succession. But the correct answer is actually any ascending numbers. I failed this example when I read it one of James Montier's writings when he posed the question to the reader. I was reading about the problem and still fell for it.

How to prevent confirmation bias in our approach to investing?  Taleb directs us back to Karl Popper and his concept of "falsification." We should attempt to prove false the ideas we are using. Again Taleb, "We can get closer to the truth by negative instances, not by verification!"  Popper, Taleb says leads the way out of our darkness, he "...introduced the mechanism of conjectures and refutations, which works as follows: you formulate a (bold) conjecture and you start looking for the observation that would prove you wrong. This is the alternative to our search for confirmatory instances. If you think the task is easy, you will be disappointed—few humans have a natural ability to do this." In the Wason study, the way to figure out the proper rule would have been to submit numbers that declined, alternated, etc. To prove what the actual rule was by ruling out as many of the opposites as possible. It is only by figuring out what doesn't work that you figure out what does.

The interesting idea to ponder is that if you are naturally a contrarian, like I am, you will be instinctively drawn to contrarian investing ideas, like value investing.  These ideas make more sense to me, than say momentum investing. But, am I really just looking for investing ideas that confirm my pre-existing biases? Perhaps.

It may also be why, even though I consider myself a value investor, I have not felt compelled to be bound by some rules that seem to appear in the blogsphere. Investing is ultimately a path, not a destination, this is just another pot hole to avoid.

Disclosure: No positions