Essential InSights

Core Topics for the Everyday Investor

Investment Bias: Confirmation

Investment Bias: Confirmation

Confirmation bias is the natural human tendency to seek specific supportive sources, or overemphasize information confirming our decisions. People will often come to a conclusion, then seek information confirming the decision. Think about buying a car, once you bought the car your brain starts to highlight all the other similar cars on the road. Surely we are not conceited enough to think “there are more of this make and model because I bought the car” and yet your brain helps to draw it into our registry.

It might seem backwards, but the seeking alpha and motley fools of the world know this and generate searches and lists confirming your already held conclusions. Confirmation bias can lead investors to be overconfident in an outcome, and as a result over allocate to a position and under hedge a risk. The investment consequences of this confirmation bias may also couple easily with some of the other biases we have discussed, most easily anchoring, endowment, and loss aversion. These “price point biases” are only entrenched when an investor seeks out other support for their price point.

Here is a great example of this in action:

Open a fresh google search and type in “is (insert company name) stock a”, and stop. Now look at the results, it will likely say “buy”, “good buy”, “good time to buy”, this is a feedback loop Google knows searchers want. Notice the lack of objectivity in the results? Our brains work similarly. We have a conclusion, then seek the supporting evidence to justify it. This overconfidence can result in a false sense that the decision is correct, and risk is not being properly rewarded. Which increases the likelihood of a misstep.

A series of psychological experiments have confirmed that in our decision making process, we expel contrarian view points early and to the detriment of rational. We carry a tendency to test ideas in a one-sided way, focusing on one possibility and ignoring alternatives. Explanations for how our brain alters the observed includes wishful thinking and the limited human capacity to process a high volume of conflicting information.

Another explanation, and one that might be more insidious, is that confirmation bias helps protect us (at least our ego) from the costs of being wrong.  Rather than investigating in a balanced, objective, and scientific way our brains protect us early from the possibility of having made a mistake through confirmation bias.

This is an obvious investment bias. Being overly critical of criticism, and overweighting the value of consensus is not unique to investing. It happens with all of our strongly held beliefs. But investing carries the permanent impairment of wealth. I’ve even heard investors say, “this is why I get a diverse range of opinions, and use several brokers.” That doesn’t solve the bias however. It isn’t the range of options, or the volume of ideas you are evaluating. Recall that Google result was broad, and deep in its sourcing. But it’s the way the brain fabricates a positive or negative weighting as it processes that information that is the root of the bias.

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Other Related Topics:

Definitions: Fixed Income

Fixed Income (or debt) represents your ownership over the repayment of a debt. Usually considered bonds, they are contracts promising the repayment of loaned money. Other forms of debt arrangements include Mortgage-Backed Securities, liens, loans, and CDs. Fixed income is called that because the return is decided on the outset – so the return is fixed from the initial offering. Because the upside is fixed from the start, the change in their pricing is less dramatic. Thus, fixed income pricing becomes less about the asset itself, and more about the prevailing rates for other options (read “current interest rate environment”). Debt is usually priced based on three variables, 1) How likely you are going to get your debt repaid, who owes the borrowed money, and what is the way they will pay it back? (Taxation, revenue, etc.) 2) how long until you are repaid your initial investment, this is called duration and indicates how long the money is at risk for. 3) the rate that the debtor is paying on the borrowed sum, usually expressed percentage as a coupon or yield. There are subcategories based on who the entity requesting the money fall into: Muni’s  – a Districts or Municipalities Debt. Usually issued to fund special projects, schools, or city and municipal improvements. In addition to the yield, these are priced for risk based on cities’ credit history, the source they plan to repay the loan (taxation or toll-based), and any available insurance they put on the bonds. Treasuries – the sovereign debt of a country. This is debt usually supported by the taxing authority of a country and its ability to create (fiat) the money they need. This is priced based on the credit rating of the country, the outlook of its currency, and the yield. Corporate – debt issued by companies and priced based on their creditworthiness. These are divided into investment grade and non-investment grade (called affectionately “high yield”) and then subdivided further. Certified Deposits (CD’s) – debt issued by banks. These are usually issued in small increments and for a short duration. The returns are insured by the FDIC (federal government) Mortgages (MBS) – These are backed by the creditworthiness of the borrower, and usually the risk is mitigated by grouping a pool of mortgages into tranches based on their collective credit rating. Collateralized Debt Obligations (CLOs) – Similar to the mortgages, this is a collection of debts that secure equipment or are backed by specialty financial arrangements.  Often backed by the repossession of accounts receivable or equipment.  

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Definitions: Equity

The term Equity represents any ownership rights over an asset’s cash flow generation potential. As an asset class, there is no guarantee of a return on your investment, it is the most speculative of assets classes and is the only asset class that can have its intrinsic value brought to zero. But because it is ownership without end, and a right to the value in perpetuity, it is also the source of the greatest returns. The math looks like this: The most common sources of Equity are stocks, your home, and other real estate assets. But equities can also include ownership in a business through your own formation, or as the result of a private placement and they also include art, royalty agreements, or leasing agreements.  Other terms for Equity are shareholder value, book value, or stake.

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Definitions: Asset Allocation

Asset Allocation is how we discuss the percent of assets in one of the four main asset classes. It is the balance of risk and reward and is the most reliable leading indicator of the intermediate and long term trajectory of a portfolio. The Asset Allocation is the first place we can adjust to a client individual’s goals, risk tolerance, and investment horizon. Asset allocation is often displayed as a pie chart and discussed in terms of the ratio. For example, the “60/40” is a shorthand reference to a portfolio that is 60% allocated to equities, and 40% to debt. These are used by many firms to place clients into a suitable collection of investments. The four assets classes we define in Asset Allocation are Equity, Fixed Income, Cash, and Precious metals.

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