At a Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial) shareholder meeting, Warren Buffett (Trades, Portfolio) said, "There's no question that what the human being is best at doing is interpreting all new information so that their prior conclusions remain intact. That is a talent everyone seems to have mastered. And how do we guard ourselves against it?"
He continues to explain that he and Charlie Munger (Trades, Portfolio), his long-time partner, are not perfect. They have made mistakes because they did not "look afresh at something." However, their results clearly indicate that they have done quite well avoiding the pitfalls of confirmation bias.
The impact of confirmation bias on investing
As experienced value investors know, confirmation bias can sink even the most promising portfolio. It blinds us to facts, deafens us to advice and lures us into traps. Understanding this tendency and proactively countering it can sharpen our analysis and improve our returns.
Understanding confirmation bias
Confirmation bias is the innate human tendency to favor information that confirms our existing beliefs. We embrace facts supporting our worldview and discount facts that contradict it. This cognitive blind spot affects every realm of life, from politics to relationships. In investing, it manifests when we:
- Dismiss negative data challenging a cherished investment thesis.
- Search for information supporting our beliefs about a stock.
- Interpret ambiguous news as favorable to our position.
When analyzing a company, our inclination is to spotlight strengths and explain away weaknesses. We seek validating viewpoints and ignore dissenting opinions.
In simple terms, confirmation bias is the urge to be right. We all feel it - the desire to protect our egos and reputations. Admitting mistakes does not come naturally. But for investors, indulging this reflex can prove costly. As Buffett warns, clinging to original conclusions despite contradicting evidence is "terribly expensive in the investment and business world."
The dangers of confirmation bias
In investing, confirmation bias whispers seductive lies:
- This stock will rebound; the market just has not realized its value yet.
- Declining sales are temporary; the weak quarters are anomalies.
- Criticisms of the CEO are unfounded. He is still the right leader.
When analyzing companies, our minds function like overzealous defense lawyers. We rationalize, deny and explain away negative data points. Once convinced of an investment thesis, we see what we want to see.
The results can be disastrous. When confirmation bias takes over, investors end up overpaying for mediocre companies, missing or dismissing real warning signs and holding losers too long while blaming the market.
As losses mount, we sink more capital into declining stocks, convinced prices will recover. Unable to objectively weigh the data, we throw good money after bad. Confirmation bias can cost investors dearly.
Buffett's approach to overcoming bias
Yet Buffett has achieved unrivaled success investing rationally without falling prey to confirmation bias. His disciplined approach relies on the following:
Acknowledging Susceptibility to Bias
Unlike most investors, Buffett admits he is prone to confirmation bias like anyone else. This self-awareness is critical, as you can't overcome a subconscious tendency if you deny its influence.
Buffett understands he has blind spots that could cloud his judgment if left unchecked. This mindset empowers him to proactively guard against bias.
Actively Seeking Contradictory Views
To avoid biased thinking, Buffett surrounds himself with contrary opinions. At Berkshire Hathaway Inc (BRK.B, Financial)'s annual meetings, he invites critics to challenge his beliefs.
Seeking dissenting viewpoints provides a crucial perspective. It confronts Buffett with facts at odds with his original thesis, preventing emotion from dictating decisions.
Evaluating Information Objectively
When presented with contradictory information, Buffett analyzes it rationally on its merits. He does not dismiss or refute evidence that conflicts with his beliefs.
By weighing facts objectively, even when they undermine his convictions, Buffett ensures decisions are grounded in truth rather than ego.
Using Feedback Mechanisms
In addition to constructive critics like Munger, disciplined self-reflection helps Buffett detect bias. In letters to shareholders, he acknowledges mistakes and lessons learned.
These feedback mechanisms are like navigation tools keeping him on course. They identify blind spots before they lead him astray.
Munger's Strategy for Overcoming Bias
While Buffett focuses on individual companies, Munger targets mental models. In a famous lecture, he details 24 causes of misjudgment, including:
- Incentive-caused bias: Our views skew based on self-interest.
- Liking tendency: We overly favor people and ideas we admire.
- Confirmation bias: We selectively notice supporting evidence.
Understanding these biases allows Munger to recognize their influence and resist them. He augmented Buffett's stock-picking prowess with a framework identifying pitfalls affecting all human judgment.
Together, their domains intertwine - Buffett applying rationality to investing, Munger revealing irrationality's causes. This holistic approach empowers their success.
Techniques for overcoming confirmation bias
Investors can undermine confirmation bias through mindful effort, even if perfect objectivity remains impossible. There are some useful techniques for doing so.
The first step is acknowledging our natural tendency to filter facts through personal biases. By becoming aware of this reflex, we empower ourselves to counteract our own blind spots.
Second, rather than solely pursue validating information, make a habit of hunting down evidence that challenges your beliefs. Putting our theses to the pressure test from all angles keeps us intellectually honest.
When analyzing data, scrutinize agreeable and disagreeable facts with equal rigor. Do not rationalize away inconvenient truths just because they undermine what you want to believe. Impartiality must override emotion.
Further, keep an investment journal to reveal flawed thinking patterns before they metastasize. Revisiting past entries provides an invaluable perspective on where we've gone wrong before.
Discuss your investment ideas with credible critics, not just cheerleaders who confirm what you already believe. Dissenting views provide crucial friction against the slippery slope of bias.
Seek to avoid emotional attachments. Rather, detach your ego and identity from investment decisions to maintain objectivity. Stocks are financial assets, not relationships. If the data turns against a company, sell rationally.
It is also helpful to reviewing past predictions. Analyze the accuracy of your old assumptions in hindsight. This instills healthy humility to counter overconfidence that clouds future judgment.
Additionally, seek out intellectual diversity. Consume information across the spectrum, not just from familiar sources that reaffirm your positions. Allow yourself to be challenged by uncomfortable perspectives.
Finally, make choices privately before declaring them publicly. Truth should be the ultimate driver of any conclusion, not pride or consistency.
Mastering our own minds is the surest path to mastering markets. With vigilance and humility, rationality can overcome instinctive bias. The goal is to make progress through greater self-awareness, not perfection.
Outsmarting our own biases
In investing, like in life, we see what we want to see. Facts bend to accommodate our feelings. Mastering this tendency allowed Buffett and Munger to amass fortunes and admirers.
By spotlighting pitfalls like confirmation bias, they remind us successful investing requires ruthless truth-seeking. We must acknowledge preconceptions, invite criticism and evaluate with open minds.
With awareness and discipline, investors can likewise avoid the blinding effects of bias. While never easy, success depends on subordinating ego to rationality. Like Buffett and Munger, we must hold facts supreme, no matter how uncomfortable for our convictions. In investing, as in wisdom, humility is power.
