PsyFi Search

Showing posts with label confirmation bias. Show all posts
Showing posts with label confirmation bias. Show all posts

Monday, 4 July 2016

Blindsided by Brexit Bias

Unbalanced

The result of the UK’s referendum on the EU caught markets by surprise. They’d soared the previous day in the expectation of a Remain vote and were thrown into turmoil when it turned out a majority of the British were less concerned with economic stability and more with mass immigration.

The polls leading up to the referendum were finely balanced; if they were to be believed then the result was far from certain right up to the end. Yet many people took the market surge at face value – that markets were pricing in known information -  and that a Remain vote was in the bag. But it wasn’t, and the whole thing is behavioural bias writ large. Not that anyone will actually learn the lessons of course.

Wednesday, 3 February 2016

HARKing Back: Lessons in Investing from Science

Confirm Ye Not

Here's what ought to be a really boring idea – we need scientists in general and psychologists and economists in particular to stop hypothesising after results are known (HARKing, geddit?). Instead they need to state what they're looking for before they conduct their experiments because otherwise they cherrypick the results they find to confirm hypotheses they never previously had.

The underlying problem is our old foe, confirmation bias. And the solution for scientists and social scientists alike is known as pre-registration. It would be no bad thing for investors to demand a similar process for fund managers and financial experts. Or, for that matter, to apply some of the ideas to their own investing strategies.

Tuesday, 17 March 2015

Mr Popper’s Predictions

In My Experience

In my experience whenever you hear someone saying "in my experience" you're about to get an earful of incoherent nonsense justified by the observer's single perspective. It's nearly always dangerous nonsense, justified by specific examples taken from a single snapshot in time.

Well, in my experience, personal observations are typified by overconfidence, colored by hindsight bias and impervious to evidence suggesting that they're wrong. They're flung about with gay abandon, but have as much in common with objective truth as a report from an analyst.  The future is unknowable, anyone who claims special knowledge is either lying or mad. And possibly both.

Friday, 13 June 2014

C is for Confirmation Bias

Confirmation Bias refers to our dedicated and sometimes demented preference for information that supports our pre-existing beliefs or decisions, and our equally fervent attempts to avoid finding disconfirming evidence. We can even get to the point of taking the latter as the former (although strictly that's a different problem, the Backfire Effect).

Thursday, 9 August 2012

Unrealistic Optimism and the Impoverished Investor

Hope is the thing with feathers that perches in my soul – Emily Dickinson
Eternal Optimists

Humanity is unrelentingly optimistic in the face of contradictory evidence.  Our ability to demonstrate unrealistic optimism bridges cultures, races, genders and societies.  We simply will not face up to the nasty reality of the real world, whatever that is.

This bias is so pervasive that it’s highly unlikely to be a social adaptation to culture and is probably an evolutionary trait, hard-wired into our brains.  No matter how it arises, it’s going to induce investors to take a positive view of the world: a view which cuts right across behavioral investing rule number one.

Thursday, 9 February 2012

Backfiring Investment Theories

Holy Theory

We’ve met the nasty nature of confirmation bias on several occasions. This is the twisted trait that sees us in thrall to the views of others around us, and helps us encourage them to maintain those views, regardless of anything resembling reality. But this is only the half of it.

No, we also have to cope with the impact of information that blows huge great holes in our world views and which undermines our most devoutly held beliefs. When faced with unequivocal evidence that shows that our favourite investment ideas are wrong we do what you really ought to expect by now: we don’t so much ignore it as twist it to our own predetermined ends. Folks, meet the wonderfully counter-intuitive backfire effect.

Wednesday, 23 November 2011

Ideology, Paving the Road to Financial Ruin

"A fool and his money are soon elected" – Will Rogers
An Emergent Crisis

In Ending the Divine Right of Bankers we looked at the way in which democratic governments have become subject to the whims of markets: and how markets may soon find themselves bowing to the dictats of voters. However, this is only half the story because it would be a mistake to see this as an orchestrated outcome by a cabal of shadowy figures. Instead it’s just happened, an emergent property of the interaction of democracy and capitalism.

Of course the road to ruin is littered with good intentions and what we’re now seeing is the natural tendency of trends to overshoot. It’s the result of a nasty combination of free market ideology taken to extremes and the self-interest of corporations, exploiting any opportunity to enhance profitability and bonuses. It is, as ever, an outcome of combinatorial human behavioral errors rather than a set of deliberate policies.

Saturday, 17 September 2011

HONTI #4: Disconfirm, Disconfirm, Disconfirm

Rule #4: Look for evidence that you're wrong, not that you're right.

Be Prepared to Change Your Mind
"When the facts change, I change my mind. What do you do, sir?"; John Maynard Keynes (allegedly: see Quote Investigator)
Once you've done your careful research, or blindfolded a bemused ape and got it to stick a pin in a list of stocks, and bought into some corporation or another, you immediately become exposed to one of the nastiest behavioral biases on the block: confirmation bias. You will, whether you realise it or not, start to favour information that supports your decision and to discount that which doesn't.

Ever get a nice warm feeling when someone tips1 a stock you own?  That's confirmation bias in action and if you let it blindside you it'll take you down, along with your portfolio.

Tuesday, 30 August 2011

Investment Analysts, Sunk By Deepwater Horizon

Flawed Analysis
“BP has a systemic problem with its culture that runs deep.”
There are unlikely to be any readers of this article unaware of the disaster surrounding BP in 2010 when their Gulf of Mexico based oil drilling rig Deepwater Horizon lived up to its name in dramatic and tragic circumstances. Since then many people have pointed fingers and made accusations but the quote above, by Hersch Shefrin, comes from his book, Ending the Management Illusion, based on an analysis of the behavioral flaws apparent in BP’s management, and written two years before the disaster at the Macondo Prospect.

Yet while Shefrin was able to identify the potential problems at BP ahead of the game not only did this not alert investors to the dangers of investing in BP it also failed to jolt oil sector analysts into any kind of action at all. And, frankly, if analysts can’t tell the difference between an oil major taking excessive safety risks and one that isn’t, what the hell’s the point of them?

Wednesday, 2 February 2011

Moral Hazard, But Thanks For All The Fish

Vanishing Regulators

Regulators spend a lot of time worrying out loud about moral hazard, the problem that occurs when people don’t have to take risks commensurate with their potential rewards. This sort of ignores the point that if moral hazard didn’t exist most of the need for regulators would disappear overnight.

Still, there’s a sneaking suspicion that a lot of the problems investors face are less to do with moral hazard and more to do with the problems caused by behavioural biases that cause organizations to fail to manage information successfully. This so-called intellectual hazard, it’s suggested, lies behind some of the securities industries biggest boo-boos.

Saturday, 30 October 2010

Monte Carlo Simulation or Nuclear Bust

Escape from Berlin

It's 13th July 1938 and an elderly lady of Jewish extraction is boarding a train in Berlin for the Dutch border, barely escaping the grasp of the Nazi authorities. In one of the great switchback points in history the onrushing locomotive of destiny has found itself diverted down a path that will lead, circuitously, to the end of the Second World War, the triumph of the great liberal democracies and the rise of quantitative financial modelling.

Her name is Lise Meitner and now, as we leave her travelling her lonely path to exile in Sweden, she has just 10 marks in her purse. And the key to the atomic bomb in her head.

Wednesday, 11 August 2010

James Randi and the Seer-Sucker Illusion

Illusion is not Forecasting

Every morning before he left home the illusionist James Randi used to take a piece of paper and write on it “I James Randi will die today”. He’d then sign and date it and slip it in the pocket of his jacket. Had he died, of course, the world would still be full of credulous believers insisting that he was a genuine psychic seer. We smart investors laugh at such fools, of course.

We shouldn’t, though, because every day we’re the victims of people just as clever as Randi and without any of his good moral sense. Every day, across the world, people forecast the unforecastable and predict that markets will boom, or bust, or stagger sideways like a drunken sailor. Eventually one of their predictions comes true and gullible people everywhere equate this with foresight when, in fact, the forecaster has simply been slipping a note in their pocket each morning. In a world where everyone predicts everything occasionally someone’s going to be right.

The Cowles Study

The evidence that most forecasters are simply practising the illusionist’s sleight of hand has been mounting for a very long time. Way back in 1933 Alfred Cowles published a paper on Stock Market Forecasting which “disclosed no evidence of skill in forecasting”. When he extended this study in the 1940’s he commented:
“The wording of many of the forecasts is indefinite, and it would frequently be possible for the forecaster after the event to present a plausible argument in favor of an interpretation other than the one made by the reader”.
Gosh, do tell.

Cowles’ research used the forecasts as a basis for actually making investment decisions – so a completely bullish forecast was assumed to cause an investor to invest 100% of their funds in the market. Computing the compounded results of acting on these forecasts led to a series of observations, the gist of which is that the forecasters exhibited no aptitude for forecasting. Indeed, they underperformed the market and were consistently, by a factor of 4 to 1, on the bullish side:
“The persistent and unwarranted record of optimism can possibly be explained on the grounds that readers prefer good news to bad, and that a forecaster who presents a cheerful point of view thereby attracts a following without which he would probably be unable to remain long in the business of forecasting”.
A 50-50 Bet

Given that markets were down around as much as they were up in the period under study and that forecasters were nearly always bullish it’s fairly easy to see that they’d be right about 50% of the time. Which is what Cowles found. In fact if you take a view that most forecasters are always bullish you can take a view that most forecasters will look like geniuses in a bull market and bozos in a bear market without exhibiting any particular skill in either direction. Similarly the smaller number of forecasters who are usually bearish will obtain the reverse position. To whit: forecasters forecast nothing, they’re simply signing their death certificate each morning.

In the current environment, therefore, we might expect to see a few consistently bearish commentators looking as though they can outwit the markets. Nouriel Roubini, aka Dr. Doom, has recently pointed out that his s track record of forecasting major moves in the recent past is very good – having called five out of six movements correctly. Only the five called correctly were all downwards and the other one was the mother of all rebounds.

Roubini is, by far, one of the most intelligent commentators on markets, but the point is that trying to figure out whether any recent record of success is attributable to skill or luck is pretty much impossible. So the question is: if forecasters are so useless why do people keep on using them?

The Seer-Sucker Theory

J. Scott Armstrong has come up with The Seersucker Theory to explain this. What he showed, through a wide range of examples taken from finance, psychology, medicine, etc was that forecasting success is not generally related to expertise over and above a pretty minimal level of competance In fact forecasting accuracy seems to drop once people get above a certain level of expertise. It’s not entirely obvious why this is but there are hints that confirmation bias is involved: seers are less likely to look for disconfirming evidence to cross-check their opinions than less confident semi-experts.

Meanwhile the seer-sucker theory states:
“No matter how much evidence exists that seers do not exist, suckers will pay for the existence of suckers”.
Or: for every seer there’s a sucker. One reason for this might be to do with avoidance of responsibility on behalf of the suckers. All too often in situations involving risk and uncertainty “experts” are called in who have no realistic chance of making a better decision than anyone else: that’s the problem with uncertainty. It’s uncertain. It’s unpredictable.

Herds of Analysts

However, Hong, Kubik and Solomon in Security Analyst’s Career Concerns and Herding of Investment Forecasts have proposed an interesting variation of why analyst forecasts aren’t very good in general. Herding – the behavioural trait that causes investors to move in a given direction at the same time – is triggered by career related incentives. This, of course, is not generally a factor for private investors and therefore is often neglected in considerations about why professionals make their recommendations.

What they find is that younger analysts tend to herd more than their more experienced colleagues: less experienced analysts tend to be punished more heavily for getting their forecasts wrong so they have every incentive to stick with the crowd. In contrast older analysts, who have presumably built up their reputations, face less risk of termination. Basically if a younger analyst makes a bold forecast and gets it wrong they’re likely to lose their job, while doing so and getting it right seems to make little difference to their immediate career prospects.

Although the study implies that the more experienced analysts are more accurate forecasters it, unfortunately, doesn’t make clear whether they do any better than chance over long periods. If Cowles’ findings still stack up the probability is not. Either way relying on consensus forecasts by great stampeding herds of perversely incentivised analysts isn’t likely to yield great results. Look for the outliers and then analyse them: still no free lunches, just hints and intimations.

Give Me Stories, Not Facts

Of course, in writing this, I’m well aware that forecasters will carry on forecasting and followers will carry on following: McKinsey have just published another study confirming nothing’s changed. When the inventors of the crop-circle came forward to explain how they’d fooled scientists the world over with a bit of ply-wood they were almost universally ignored. James Randi has made a second career out of debunking mystical charlatans who prey on people’s gullibility. Yet still they believe and often react violently to having their illusions shattered. It’s as though we can’t grow up and face the real world: it seems that fairies, dragons, magic and mysticism are so much more attractive than the grim reality of credit card repayments.

And this is the hidden truth – we find stories more congenial than facts. Markets are driven less by fundamentals and more by tales of derring-do. Forecasters are story-tellers not diviners of the future. Like all authors of fiction we should enjoy them for what they are: just don’t confuse their narratives with proper investing.



Related articles: Investing With a Time Machine, Investment Forecasts: Known Unknowns, Real Fortune Telling

Wednesday, 19 May 2010

Money Matters, Your Opinion Doesn’t

Blame the French

Our brave new world is filled with a cacophony of opinions; everyone’s an expert. The proliferation of media channels, accompanied by ever more desperate attempts to keep up with social networking and inclusivity trends, is leading to a world governed by the lowest common denominator. Now get this: I want to be informed by people who actually understand what they’re talking about, even while reserving the right to disagree with them, rather than by someone whose main skill is in double-jointed thumbery and text messaging.

Aliens viewing the output of terrestrial media from afar are probably wondering what type of disease is decimating the intelligence of the average Earthling. This babble of uninformed opinions is swamping the already low level of intelligent comment available and nowhere is the problem greater than in finance where people start with the view that possession of a small amount of capital and an internet connection makes them gifted and talented investors. Still, if nothing else, we can probably blame the French.

Saturday, 30 January 2010

Confirmation Bias, The Investor’s Curse

Behavioral Biases (7): Confirmation Bias

The problem of confirmation bias – the tendency of people to seek evidence confirming an already held opinion and to avoid looking for that which might upset their carefully constructed mental models has attracted a lot of attention from researchers. It occurs across all domains of human endeavour and triggers all sorts of implausible behaviour, yet investors and institutions remain in its thrall.

We find examples in law courts and doctor’s surgeries, in scientist’s laboratories and the lairs of legislators. So we shouldn’t be surprised to find it coursing through the veins of economists and investors, colouring their every thought and structuring their every idea. Of course a rational market participant, faced with a theory built on a crumbling cornerstone will abandon their ideas and look for some new ones. As you’d expect, therefore, we do no such thing, clinging irrationally to the wreckage of our dreams as they collapse around us.

Sunday, 29 March 2009

Bulletin Boards are Bad for Your Wealth

Buyer Beware of the Boards
 
Lots of us, including me, frequent investment related bulletin boards discussing shares and such stuff. They’re full of like-minded people, offering opinions on various investments. If it’s what you’re into they're fun, informative and can generate lots of useful ideas.

They can also be extremely damaging to your investment returns. Bulletin boards are exactly the wrong way to discover investment information unless you know precisely what you’re doing.