Confirmatory bias for a stock can backfire
Use discretion and do not acknowledge when the mind goads you to arrive at a conclusion
by Vivek Kaul/Mumbai/DNA Money
The most important single factor in shaping security markets is human psychology
– Gerald M Loeb
Shashidharan Pillai is a worried man these days. The price of his favourite midcap stock, after reaching an all time high of Rs 112, had been falling for sometime now. As the price was falling, Pillai thought it was a good time to buy, as this would average down the price of the stock for him. Pillai had bought 100 shares when the price was at Rs 105. And now that the price was Rs 75, buying 100 shares would make the weighted average price Rs 90 ((105 x 100 + 75 x 100) 200).
So for Pillai to make a profit the price of the stock would have to go beyond Rs 90 instead of the earlier Rs 105. But that did not happen. The price of the stock kept falling and instead of the price averaging out, Pillai was stuck with an even bigger loss.
The question to be asked here is, “Why did Pillai not sell? The evidence of the company not doing well was in front of him. The company had lost its biggest client from whom it got nearly three quarters of its revenues.
Pillai kept looking for information that supported his decision of holding on to the stock. What obviously helped him was the fact that of the many analysts in the market there was always someone who had a buy recommendation or a hold recommendation on the stock.
At the same Pillai avoided all the information that told him to sell the stock. Pillai was suffering from what is called the “Confirmatory Bias”. Lars Tvede, in his book, The Psychology of Finance, points out “Memory researchers have found that when people are motivated to arrive at particular conclusions, they unwittingly search their memories selectively for episodes and facts that will support their desired conclusion”.
Confirmatory bias is extremely relevant to stock picking. Investors generally tend to go with other investors whose views on a particular stock are like theirs. This impact can be clearly seen in chat rooms postings on websites which discuss stock picks. Investors generally tend to click more at postings which go with their view on a particular stock.
Confirmatory bias is also helped by what is called the anchoring effect. Analysts often cite targets for a stock. The idea at times is to try and influence stock market investors by putting numbers into their heads. As John Allen Paulos points out in his book, A Mathematicians Plays the Stock Market, “The reason for success of this hyperbole is that most of us suffer from a common psychological failing. We credit and easily become attached to any number we hear. This tendency is called the anchoring effect”.
Investors suffering from confirmatory bias get anchored on to numbers that support their beliefs. This number can be future expected earnings of the stock an analyst may have announced. They also tend to believe that since the stock reached a particular price high, it will do that again in the days to come.
(The example above is hypothetical)
