Chapter 19

Ask why not? (confirmation revisited)

Everybody has some idea of what happens when we fall in love with another person. We tend to see all their good points, exaggerating some of them in our mind and maybe imagining some that don’t exist. We readily find more good points. More importantly, we unconsciously overlook their bad points. We probably hardly notice their bad habits and, if we do, we find it easy to rationalise them away. We might even harbour an inner belief that the object of our love will change and any aspects of their personality with which we are vaguely uncomfortable will fade away. If someone brings one of our beloved’s bad behaviours to our attention, we will tend to defend them strongly, denying that the behaviour is important or a problem.

Now consider Mark. He is an experienced medical professional, trained in scientific method and the analysis and diagnosis of problems. In conversation with a colleague, Mary, he mentions that he has some money he is looking to invest. Mary tells him that she has just invested in MedicineDirect, a new company being set up by her brother to supply prescription drugs to patients directly, using internet ordering and mail delivery instead of through a retail pharmacy. Mary is very enthusiastic about the idea and convinces Mark that he should look at it.

The next day, Mary gives Mark the prospectus. She has flagged many of what she thinks are the important points in favour of the new company with tags and over-lined them. Mark is a busy man, so he finds it easy to pick up the arguments in favour of the new business model from Mary’s highlighting. He notices a lot of accounting data, which he finds is a bother to understand, but there are some simple graphical representations of projected sales, profits and dividends that look great.

Mark mentions the investment idea to his wife, Anna. As it happens she has just that day been to the local pharmacy to find that a drug she has been prescribed for some years had been dropped from government subsidy and she had to pay much more than the previous price for it. Accordingly, she is in favour of anything that will bring down the price of drugs, which she sees as an important and growing problem. Nevertheless, Anna knows that neither she nor Mark are experienced investors, so she suggests they get some advice about MedicineDirect.

Mark notices that the prospectus lists a broker who is sponsoring the new company on the stock market. Who better to know about the new company, thinks Mark. He telephones the broker and speaks with a client adviser, Jason. Jason tells him that he has personally had lunch recently with Mary’s brother and his accountant. Jason is very enthusiastic about what they told him and assures Mark that, although he is not allowed to buy stocks himself, he has arranged for many of his friends to be allocated a healthy parcel in the initial public offering (IPO or float).

When Mark gets home, Anna tells him that she has been on the internet and found a magazine article about upcoming IPOs that paints a very glowing picture of the prospects for MedicineDirect. She also found that some investment chat rooms were buzzing with enthusiasm from investors who had subscribed for stock in the new company. Mark and Anna decide to buy a significant parcel in the IPO and over dinner imagine how they may be able to retire earlier from the proceeds of the investment.

Unfortunately, this story, like many similar to it, does not end well. They pay 50¢ for the MedicineDirect stock in the IPO. It starts trading at 78¢. Over the next few days it soars to $1.30 as investors scramble to get on board. Mark and Anna enthusiastically seek out reports in newspapers and magazines extolling the promise of the company. Over the next six months, MedicineDirect rises steadily to around $3.00, but then levels out. Then the stock starts to slip a bit to $2.70. Mark checks with Mary, who checks with her brother, who assures her that all is well. There are just a few hold-ups getting through government regulatory requirements. Mark phones Jason, who assures him that these problems are only temporary.

Over the next year and a half, the price of MedicineDirect stock falls to $2.40, recovers to $2.60, falls again and so on, slipping inexorably lower towards $1.50. Although the chat rooms have gone quiet, Mark and Jason decide it is just bad luck and it will take longer than expected to get the business going. A long article in a magazine explaining that internet/direct mail commerce is the new wave, and that MedicineDirect is one of several companies that are set to exploit the opportunities, sustains Mark and Mary’s resolve.

MedicineDirect clears its regulatory hurdles and starts operating. The price has fallen below $1.00, but rallies to $1.20 on the news. Mark and Anna breathe a sigh of relief. However, over the ensuing months the price slips lower and lower, dropping to below the 50¢ Mark and Anna had paid for them. It seems that the battle with regulators cost more than planned and this reduced the funds available for advertising. Customers are slow to embrace the new method of buying. Because of the lower than expected sales volumes, costs are higher than planned and MedicineDirect begins to run out of money. The price slips to 12¢. MedicineDirect stock is suspended while the company negotiates with its bankers. However, nobody will lend the company more money and the directors call in the liquidators. Mary’s brother declares he is bankrupt.

Was this just bad luck? Probably not, because what Mark and Anna did in making this investment was to fall for one of the most common mistakes we all make. They fell for confirmation bias. This is a largely unconscious cognitive bias that was touched on earlier in the chapter on overconfidence.

Just like the lover we described at the start, we fall in love with our investments. We then tend only to notice and look for evidence that confirms what we want to believe. Worse, we also tend to avoid and ignore evidence that might contradict our belief. Mark and Anna sought advice only from people who had a personal interest in, or had already formed an opinion in favour of, MedicineDirect.

Confirmation bias exists because none of us likes to be wrong. We find it difficult to accept evidence that tends to cast doubt on our decision. We also invest our self-image in our decisions, especially if we have made them public.

However, there is more to it than that. Research has shown that in trying to test a hypothesis, the natural tendency is to look for confirming evidence, the positives, and to not look for contradictory evidence, the negatives.

As an investor, we will be looking initially to buy stocks. What must be borne in mind is that we buy stocks from someone. They might be the owner or promoter of the business in an IPO or they may be an existing stockholder on the stock market. If we can only see how we can win from buying a stock, we should stop for a moment and ask why anyone would be selling to us, at least at the price we find so attractive? There must be a different view. It may be mistaken, but equally, we may be the ones who are wrong.

There are two keys to dealing with confirmation bias in investing. The first is to be aware that it affects everybody and we are no exception. Recognition of the trap is the first step in avoiding it. The second is to seek out the negatives. The more certain you are that you are right, the greater the danger of confirmation bias. Ask yourself what could go wrong? Don’t call the broker sponsoring the issue: call a competing broker. Don’t ask the sister of the promoter: ask his competitors.

Summary

Confirmation bias is a common cognitive bias. It happens when we seek assurance about an opinion by looking for more and more confirming evidence. We do not make an effort to understand why someone would sell to us at the price offered. We are in the greatest danger of confirmation bias when we are most certain of our opinion.

Strategies

1 The best approach is always to make a list of the pros and cons of the stock we are thinking of buying and then weigh them up for a balanced view. If we can see only the pros and very few, if any, cons we need to seek out the negatives. If we have to ask others to help us work out the reasons against buying the stock, we should avoid starting by telling them how much we think of it, and nor should we ask for their overall opinion of the stock. Instead, we should ask specifically for the points against buying. Ask them to argue the other side of the case to you, taking the role of a devil’s advocate. Finally, also ask them to challenge all of your points in favour of buying.

2 Avoid seeking opinions from people who have an interest in you buying the stock. The management of the company, the house broker’s analyst, journalists who have written favourable articles about the company, employees of the company, and anyone who is a supplier to or does business with the company should be avoided. It is far better to ask the management or employees of a competitor or someone who is knowledgeable about investing and can take a totally disinterested view.

3 When we have money to invest in a new stock, it is best never to consider only one stock to buy. Have a list of four to six stocks and assess them against reasonably objective measures in weighing up which is the best one. We are likely to be surprised quite often that our original fancy does not stack up as well as we thought when it was the only one we were considering. This strategy of considering alternatives also helps avoid opportunity cost: the better return from an alternative that is foregone by investing in the stock that was our sole original focus.