Everyone knows that we are not hyper-rational calculating machines. We are prone to bias in how we seek out and process information. These biases are often invisible to us, but make a big impact on our behaviour and decisions. It is not only interesting but also important to understand your own tendencies, and as a trader and investor critical to improving your performance.
It also applies in the sphere of economics, where behavioural studies show that people do not behave in the way that the neoclassical “rational” person is supposed to.
Confirmation Bias
The cognitive bias that gets most attention is confirmation bias i.e. a tendency to search for and favour information in a way that supports your beliefs. This is critically important for anyone who makes important decisions. It manifests itself in a variety of ways:
- Seek out information to support and reinforce our beliefs
- Ignore information that undermines our beliefs
- Surround ourselves with people who agree with us
- Like and reward people for agreeing with us
- Dislike and punish people who disagree with us
I remember seeing lots of these behaviours when I worked in a large organisation. Of course, you will probably see it most clearly in the people you dislike, but perhaps be rather blind to it in yourself or your friends.
In modern politics, politicians seem to be particularly prone to it:
- Trump – an extreme case, a caricature of confirmation bias
- Theresa May – surrounded by a small loyal group and not listening to outside advice
- Jeremy Corbyn – adored within his bubble
It’s easy to see that confirmation bias leads to:
- Over-confidence
- Polarization
- Wishful thinking
These characteristics may not be harmful to you in your life or career. That is why they can persist. For example, for many senior politicians, it has clearly not harmed their careers. Over-confidence is simply seen as confidence and that is appealing to people who want to believe in a leader. However, characteristics such as these are fatal to someone who wants to make successful investment decisions. Before I move on this in the next post, I want to introduce another source of bias that is deeper routed, more important, harder to detect and most people may even not think of as a bias!
Beliefs and confirmation bias are only one part of decision making.
Desire
We all have desires, they are a powerful and primal part of our being. You probably think of them as part of your emotional brain but have you considered that they have a relationship with your beliefs – a bias to believe what you want to believe.
It is so prevalent the examples are legion. Here are some examples:
Of course, you can have beliefs that do not align with desires, the relationship is not deterministic. You can support Man City but think Chelsea will win, or you can support Chelsea and think Man City will win. However for the most part, it seems more natural and harmonious when our beliefs and desires do line up. If you doubt the power of desire, please spend some time to make a list of your current beliefs which are strongly at odds with your desires. I think the list is not so easy to come up with.
It is then important to consider what drives what in this relationship. There was a recent study in which psychologists (Tappin, McKay and Leer) designed an experiment to separate beliefs from desires. They gave opinion poll data to US voters and what they found was that desires dominated. For example, optimistic Clinton supporters and pessimistic Trump supporters both believed that Clinton would win. When given new polling information suggesting that Trump would win the Clinton supporters ignored it and the Trump supporters incorporated it to become more optimistic. https://www.nytimes.com/2017/05/27/opinion/sunday/youre-not-going-to-change-your-mind.html. They called this “desirability bias”.
It is how our desires and beliefs interact that make this effect so important:
- If our desires and beliefs are aligned
Confirmation bias will be even stronger. - If our desires and beliefs are not aligned
Then we change our beliefs!
Often confirmation bias is easy to spot, but the desires that predispose you to seeking confirmation bias are hidden and much more important.
This result is not surprising to anyone who has worked on a trading floor or played high stakes poker. The strong emotions and desires that come from the large sums of money involve permeate the environment and can easily overwhelm most people. For a trader or investor to be successful you need to be able to make good decisions. If you have a significant bias in your decisions making then you will fail, sometimes catastrophically.
Conclusion
Your desires will have a huge impact on your beliefs, how you process new information and the decisions you make. The problem is most people believe that their beliefs are rational and do not understand their often-emotional core. Developing ways to deal with this can have a dramatic impact on your performance. In the next post, I will talk about some ways I have dealt with this in my career.
Applied Macro 
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