Investors must shatter the echo chamber

Equity investors must be aware of the tendency to seek information that confirms our beliefs.
By Guest |  18-12-18 | 
 
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Morningstar invites thought leaders from the investment community to share their insights. Views expressed are personal and should not be construed as investment advice.

Global markets have whipsawed violently back and forth since October. Don’t look now, but the four horsemen of the impending apocalypse, FANG stocks (Facebook, Amazon, Netflix, and Google) have held up impressively well in recent broader corrections! Continued relative strength in the face of such volatility and the strong statistical basis of a year-end rally are two legs for the stool. The third leg, taming of trade tensions has already begun.

December is my favourite month, a myriad of holidays abound and a mood of general cheer is in the air. It’s also a good time to take stock of stock markets and our emotions as we enter a traditionally ebullient phase of the year.

Within an India context, just a few short months ago, a hard rain was falling and the familiar list of bad actors – crude, currency, NBFCs - were up in flames. (Un)surprisingly the market has recovered and seem reasonably poised for another round of year end “Santa Rallies”. This would be despite local polls presenting problems for our ruling party and the rather unceremonious departure of Urjit Patel.

Financial media narratives always change suddenly. Their headlines strum along to confirm the new narratives, culling out the old. Confident buy calls replace the symphony of sell calls gone by, but one is reticent to follow these revered pundits. The pundits who seem to know everything. Yet what the pundits know, is all in retrospect. 

Beware those wise ones who seem to know exactly which seam needs attention, only after it’s already torn.

A more practical approach is to focus instead on the most common behavioural biases we face in investing, and life at large. Confirmation bias is one that lays bare our flawed decision making every-day, on-line, at work and home.

In the investment world, confirmation bias is the primary cause of over trading, averaging/riding down losers, falling into value traps and for pyramid schemes.

Confirmation bias is the tendency to find and embrace confirming evidence for what we already believe. And a rejection of any evidence found contrary to our beliefs.

Although simply being aware makes a massive impact on reactionary decision making, here are three ways to recognize and rise above this bias.

Question everything

Basing decisions on an assumption or gut feeling alone is a demonstrated losing strategy. One can go about cherry picking specific instances where a gut feeling has panned out. But it’s oppressive to do the opposite. We love easy decisions and those who stand to gain from our naivety, will find innovative ways to nudge us onto the nice and easy path. A seemingly easy decision where we know a decision should be hard, is a sign. A sign we are fooling ourselves and we are the easiest to fool (h/t Richard Feynman).

Articulate the opposing view

Ideally, we come to a decision based on a specific set of inputs. We must also be able to see why someone might decide the opposite, looking at the same set of inputs. If we can’t do this, either we have bad/biased data or we made the decision based on belief, not on evidence. Confirmation is easy living inside an echo chamber. We must find opposing views if we are to shatter it.

Observe a cooling off period

Our daily decisions require immediate action. A cooling period is impractical but can work even if significantly shortened. We should make decisions in a calm and rational manner, not in the heat of a moment. This is especially true when markets are making massive moves and our media pundits are selling the flavour du jour.

Volatility in the market is a 2-sided coin. To paraphrase Howard Marks – all bull markets sow the seeds for their own eventual destruction, just as all bear markets lay the groundwork for the next move up.

We can’t possibly eliminate all bad or biased decisions from our day-to-day lives. But we can try to fortify our decisions from being swayed by misinformation and malarkey. By recognizing behavioural biases, we stop emotions from clouding judgment of a yet-to-be apparent future. Expectations of the future must always be adjusted from a rational baseline. One which is equanimously mean reverting and eloquently elucidated by Marks in this interview.

Cheers to the bulls and the bears!

Faiz Memon is a SEBI-registered investment adviser, healthcare entrepreneur, and a cryptocurrency and blockchain enthusiast. This post initially appeared on his blog.

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