Confirmation BiasMonday, July 7th, 2014
We all would like to believe that we carefully gather and evaluate facts and data (both positive and negative) before making an important decision. This can be much harder to do in practice than we think. We all have a tendency to search for or interpret information in a way that confirms our preconceptions, which is otherwise known as confirmation bias. Like recency bias, it is one of the many behavioral biases that can cloud our perspective. It can also hamper our ability to successfully choose investments.
In the context of investing, confirmation bias suggests an investor would have a greater likelihood of seeking information to support his or her original idea rather than looking for contradictory information.
An example of confirmation bias would be if an investor learns about a stock from an unverified source and becomes intrigued by the idea. The investor could then choose to research the stock in order to “confirm” that its touted potential is real.
The risk is that the investor only focuses on information that supports the initial view (for example, growing cash flow or earnings). At the same time he or she may give short shrift to potential red flags such as loss of critical customers or declining market share.
How BWFA Avoids Confirmation Bias
At BWFA, our research process starts with an initial assessment of how attractively valued an individual security may be. Our next step involves reading the company’s SEC filings to gain a better understanding of its business. Importantly, these documents are fact-based and do not provide opinions. We also review financial metrics that help us assess how management allocates capital and how efficiently the business is run.
Next we review conference call transcripts and company presentations. After gaining a basic understanding of the company and its business, we try to gain further insights into its industry and its outlook. Only after completing these steps will we review analyst research and other reports to understand the perspective others may have about the company. We also endeavor to find both positive and negative opinions, as we want to try and understand the potential risks as well as the benefits associated with ownership.
While a positive article about a company or the results of a screen for certain characteristics may have given rise to the idea, we do not revisit these at the start of the research process. It is only at the end of the process that we may revisit them. Our valuation-based approach also helps keep us from buying “hot” stocks whose price appreciation can be momentum driven. By approaching potential investments in this disciplined way, we attempt to reduce the chance of confirmation bias as much as possible.