A startling number of investment decisions go wrong every day courtesy a firmly ingrained tendency that most of us have; that is, the proclivity to seek out information that is consistent with our already pre-existing points of view. This deleterious mental bias is known as the "confirmatory bias".
It's far more comfortable to read books that agree with your point of view, to watch news channels that espouse the same opinions that you hold, and associate with all those nice people who exchange pleasantries with you and go on to echo your sentiments on any given issue. In fact, I would go so far as to suggest that it is this base human tendency that serves to glue similar people into firm and largely beneficial societal ties. In the investing world, however, few things are more dangerous and loss-inducing as the confirmatory bias.
An extreme but rather amusing example of this bias is the famous incident involving Lady Tichborne in England in the 1850s. Her beloved son Roger, purportedly lost at sea in 1854, miraculously 'resurfaced' in Australia after Lady Tichborne's frenetic efforts towards tracing him. Despite a significant degree of evidence that the resurrected Roger was in fact, fraudulent (body weight, appearance of birthmarks and a disappearance of tattoos, to name a few), Lady Tichborne refused to alter her already entrenched belief that this new and rather lardy gentleman was, in fact, her long-lost son. It was only years after her death that the imposter was proven to be a certain Arthur Orton, and rightfully persecuted and sentenced to jail!
So, what do great investors and portfolio managers do to overcome this mental bias? They actually follow a reverse process called 'falsification'. The falsification method involves detailing all the ways in which something could go wrong with our currently held hypothesis. Glum and pessimistic as it may sound, the falsification process has saved many an investor from jumping in with both feet, into bottomless pits!
Michael Steihnardt, the legendary hedge fund manager and founder of Steinhardt, Fine, Berkowitz & Co, goes a step further and periodically (when he feels uncomfortable about the general state of his investments) wipes his slate clean by liquidating all his holdings. Although this is an extreme example of investment catharsis, it goes on to demonstrate a disciplined (and a tad maverick!) approach towards breaking free from our preconceived notions on a periodic basis. "Sometimes, it felt refreshing to start over, all in cash", says Stienhardt in his autobiography "No Bull".
Some have hypothesized that the mother of the conservatism bias is another, deeper bias called the Sunk Cost bias. That is to say, many of us continue sticking to our preconceived notions simply because we've already sunk time (and if we've lucked out, money) into subscribing to that particular point of view for an extended period of time.
What about you, as a lay investor? What can you do to beat this pernicious little trap before you make an investment? The answer is disappointingly unassuming - set up a checklist. As renowned Surgeon and writer Atul Gawande propounds so beautifully in his important book "The Checklist Manifesto", a simple pre-investment checklist can help you break out of the prison of your beliefs and make smarter investment decisions. If you're lucky, you might just end up proving yourself wrong!
More to come on the subject of a 'pre-investment' checklist for lay investors looking to invest into mutual funds. Keep watching this space.
