Beware Of Confirmation Bias

Albert Einstein once said:  “Few people are capable of expressing with equanimity opinions which differ from the prejudices of their social environment. Most people are incapable of forming such opinions." 

To Mr. Einstein, it was quite clear that people have their biases, and it is extremely rare that they are able to disassociate themselves from those biases, if ever.  It is for this reason that investor seek out analysts who provide support to their pre-determined biases.  We call this bias confirmation.  And, almost every investor you speak to is afflicted with this condition.

This phenomena is quite evident on Seeking Alpha, which is a crowd sourced website.  Most readers gravitate to an analyst simply because that analyst supports the readers own personal perspective  Therefore, this process turns into a popularity contest with regard to the analysts you “support” rather than actually seeking out intellectually honest perspectives about the stock market.

Analysts are also infected by the same confirmation bias disorder.

Andrew Lang (1844-1912) once quipped:  "He uses statistics as a drunken man uses lamp-posts... for support rather than illumination."

And, this is exactly how analysts further their own confirmation bias.  They have made their determination about the market, and then seek out statistics and facts to support that perspective.  

This is how herding in our financial market works. The analyst has made his/her determination about the market, the investor has made his/her determination about the market, and then they find each other on a site such as Seeking Alpha, and then support each other in the comments section, which then perpetuates their combined confirmation bias.  Ultimately, do you think this to be healthy for your investment account?

In 1996, Robert Olson published a study in the Financial Analysts Journal in which he studied the effects of herding upon “expert” fundamental analysts’ predictions of corporate earnings. After studying 4000 corporate earnings estimates, he arrived at the following conclusion:

“Experts’ earnings predictions exhibit positive bias and disappointing accuracy. These shortcomings are usually attributed to some combination of incomplete knowledge, incompetence, and/or misrepresentation.”

Mr. Olson’s article suggests that “the human desire for consensus leads to herding behavior among earnings forecasters,” with the herd always looking for the current trend to continue unabated and indefinitely.

Bob Barbera, chief economist at Mt. Lucas Management Co., said that “allowing the pace of economic growth in the last three to six months to dictate the next three to six months beats most forecast – except when it matters.”

What Bob is saying is truly amazing, that is, if you are a thinking person.  In effect, he is saying that as long as the herd is moving in the same direction over a 12-month period, then the first six months will dictate the direction of the last six months.  Well . . .duhhh!!   

Yet, it is the last four words of his statement that really means anything.  Bob is clearly implying that if the market changes direction in the second six-month period, then the first six-month period will not be able to forecast the second six month period.  That is when it matters.  

In other words, as long as the herd is moving in the same direction, it will continue to move in the same direction . . .  until it turns.  Isn’t that just brilliant?  Yet, this is what herding is all about.

The great majority of the time in the stock market, it makes sense to run with the herd.  When you try to turn against the herd while it is stampeding, oftentimes you get trampled.  Yet, there are times in the market when running with the herd will lead you off the cliff.  And, if you mindlessly run with the herd without having a grander perspective, you are bound to find yourself falling off that cliff.  That is when it matters.

So, how do you identify that period of time when it matters?

That is where an understanding of market sentiment is key, so you can understand when it is ready to turn.  Market sentiment provides early warning as to when you are approaching that cliff, and it allows you to move to the sidelines and allow the herd to run off the cliff without you.

So, feel free to come join me at our new site – FATrader.com, where you can directly chat with me and our other analysts who have over 100 years of combined experience in the financial markets.

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