Thursday, November 5, 2015

Confirmation Bias

As background, I've been learning over the past year or two about behavioral biases that impact my perceptions, observations, and thinking about things.  The contexts apply widely, although the specific application is to try to be aware of biases in my thinking toward investment.

I wanted to talk a bit about confirmation bias after having some insight as to its usefulness today.

Confirmation bias is simply our tendency to see what we expect to see, interpret data in a way that confirms our preconceived model of the world.  The corollary is that we tend to discard/discount data or observations that don't fit what we expect to see.  Obviously in investing this can be dangerous - it means we're likely to interpret information about the market or an investment in a way that fits our preconceived ideas about that investment.  A bullish investor will tend to look for and "see" data to support his bullish thesis, and a bearish investor will tend to look for and "see" data to support a bearish thesis.


I find confirmation bias a difficult tendency to overcome.  Here's an online test that gives an example:

In the above, I read alot into test shown above - and was largely seeing what I was expecting to see - rather than seeing what was really there.  I can't help having a tendency to see things that I expect to see.

Now, to bring this around to today - my question is why is confirmation bias such a strong tendency?  Well, my answer is that I think confirmation bias is highly useful in many circumstances, and I'll describe a situation from today.

I've been doing some work under my house, putting in some supports underneath a shower pan.  Now my crawlspace is tight, and I am a big guy, and I liken it somewhat to going through birth everytime I go under the house and try to squeeze myself back out.  Squeezing in the tiny door, squeezing under flexible vent tubes, squeezing under plumbing pipes, etc.  The basic idea is that it is very tight down there, not alot of room to move or even look around.  Plus, there's not a lot of light, so I'm somewhat sensory deprived.

So I squeeze myself in under the shower, twist onto my back and am looking up at the shower pan.  In a bag I've drug bunch of tools and supplies in there with me.  tape measure, pencil, paper, gloves, maybe a few other things .  So I'm on my back looking up at the shower pan, concrete blocks pinning me in pretty tightly on both sides and the drain pipe kindof pinning me from the top.  One of my little Harbor Freight LED lights starts to flicker on and off (this is the light I'm referring to - I like it) so I'm thinking I better get my backup flashlight handy.  (I later took an extension cord and lamp down there, but initially I was just using a small battery powered light to see what was going on.)  I'm really not able to move my head enough to see what I'm looking for in the bag that I brought along, so I'm basically going by feel at this point.

For whatever reason, as I am reaching in for my little flashlight and feeling around and having difficulty finding it, I started thinking about confirmation bias and how useful it can be in a situation like that.  I kid you not, I was laying there under the house in the dark thinking about the usefulness of confirmation bias.  I knew I was looking for a small tubular metal LED flashlight, so I blindly reached down toward the bag (it's down near my knees) and started feeling for things.  I wasn't concerned about taking in other information about the worn leather texture of my gloves, or the ridges on my screwdriver, or a wrinkled up piece of paper, or the handles on the bag that kept getting in my way.  I was just digging around in there with single purpose of finding that other flashlight in case my other light went out - because I really didn't want to try to squeeze out of there in the dark (although that would've been a good story).  In this case, I was looking solely for information that confirmed that I had found the flashlight that I was looking for.  I ignored everything else.  Pure confirmation bias.  And I think it can be a useful bias in many of life's situations.

So why are we wired for confirmation bias?  I think it's because it's useful in many situations.  It reduces the complexity of a problem considerably and helps us focus on what we're looking for.   Now clearly, where this gets us into trouble is when this bias causes us to miss important details, or to see things that aren't there.  My screwdriver sortof felt like the flashlight, so for a moment I thought it was the flashlight.  Similarly, if I would've reached down and grabbed a possum by the tail it probably would've taken me a moment to figure out what was going on because I wasn't in a mental state to digest that bit of information.

Let me turn this into a specific line of thought on investments.  I have an overweight position in several energy stocks currently, and I expect the price of oil to recover - but it is taking longer than I expected.  So naturally, I try to realize I tend to view the world through the lens of an expectation of oil price recovery.  I look for stories that tend to validate this type of thinking - indicating US crude production is dropping, rig counts are declining, that international demand might pick up if global economies start growing more, that budgets of many oil producing countries are strapped so OPEC has incentives to increase prices, that instability in various regions could produce supply disruptions, price is below marginal cost of production, etc.   There are so many reasons for me to think that oil prices will recover.

But I also try to realize that I tend to discount or downplay the reasons that oil prices might have a more protracted downturn, because that doesn't fit my prior expectations of a price recovery.  Maybe the fracking technology is so good now that costs are fundamentally lower perpetually.  (While US fracking is a small part of the global production, it is a large part of the recent growth, so on the margin the boom in US fracking is impacting global supplies disproportionately.)  Maybe excess supply will be persistent.  Maybe this is the mother of all market share wars, and Saudi Arabia is trying to run US fracking capacity out of business?  There are lots of reasons that the price of oil could stay low for a longer time than I expect.

So in the end, recognition of confirmation bias has me tempering my bets in energy.  I am overweight the sector, but I easily could've been more if I wouldn't have thought in terms of probabilities like Howard Marks discusses.   As he explains, more things can happen than will happen, and we have to position ourselves appropriately.  This goes somewhat against the Buffett/Munger principle of making big concentrated bets, but then again, I'm not a Buffett or a Munger.  (I'm no Howard Marks either, but you know what I'm saying).

By the way, to guard against confirmation bias, Charlie Munger advises to invert the question - and ask what kind of information should I be looking for if my thesis is wrong.  So Munger's question would likely be more along the lines of "What type of evidence should I be looking for to confirm that the price of oil is going to stay depressed for an extended period?"   This approach takes advantage of confirmation bias by refocusing us on the inverse of our expectation.