Tag: Bias

The Backfire Effect

Recently in the news

  • You may find it puzzling that Republican voters are still backing Trump.
  • You may be amazed that the same voters do not believe that Russia interfered with the election, or that there is any connection to the Trump campaign.
  • In that case you must be shocked that the recent Donald Junior revelations have make their belief in ‘no collusion’ even stronger.[1]

But then again, is it that surprising? I previously discussed confirmation bias and desirability bias (https://appliedmacro.com/2017/07/10/decision-making-systematic-flaws-biases/ and https://appliedmacro.com/2017/07/12/desire-the-fatal-flaw/)) but in this case feels like there is a different driver at work.


“Backfire effect”

This recent paper [2] found that “direct factual contradictions can actually strengthen ideologically grounded factual beliefs”. This is the “backfire effect”.

In contrast to what we saw previously:

Here we have:

The more evidence and the clearer the evidence against Trump, the more strongly his supporters believe him innocent. Trump supporters are not backing him because of facts or policies, this is about ideology and culture and it is a battle. Facts are irrelevant.

There are plenty of examples which demonstrate this. Tim Harford talks about how the tobacco industry managed to delay regulation for decades despite overwhelming evidence showing the link between smoking and cancer. [3] Another favourite example is what happens to cult members who believe that the world will end on a specific day. They give away their possessions and prepare for their ascension to heaven/alien spaceship. When the day arrives and nothing actually happens, they do not lose their faith; their faith in the end of the world actually increases. Perhaps the “backfire effect” also explains why Tony Blair’s support for the Iraq War became more fervent despite mounting evidence against the entire premise.

Back to Trump-gate

Given this, I fear that this ever-larger number of smoking guns will not help the Democrats much, even with increasing suggestions of criminal activity not just from the Trump campaign but from the Trump family itself. The way to defeat the Backfire effect is not to counter with ever more evidence. There was no possible evidence based argument that would have changed Blair’s mind about war.

The best approach is to build a compelling alternative narrative. Corbyn did this very successfully in the last election, making no attempt to defend himself against May’s attacks, focusing only on what he wanted to talk about. He did not change people’s minds about Trident, he stopped them thinking about it. What we focus on is far more important than the content of the debate.

Like all cognitive biases, spotting them in others is far easier than in oneself. We can all fall foul of the “backfire effect” when it comes to our most central values and beliefs. For business and investment, it has perhaps led to the most catastrophic of errors. The disasters of RBS, Lehman and Enron can be traced to core beliefs that proved successful at first, but then warning signs were ignored as the management became ever more evangelical in their confidence that their path was the right one.

When we are looking for investment analysis or advice, then we should be very wary of those with high and unchanging conviction. Some of the ones I regularly come across: the EU will break up/stick together or China will implode/ take over global dominance or the bond market will crash/inflation will never return. They argue passionately and eloquently (they are well practised) but are the ones most likely to be victims of the “backfire effect”. The element that makes them so popular as guru strategists and TV pundits makes them highly unreliable sources of investment advice.

Perhaps we should simply recognise that we may easily fall for this as individuals, but by building diverse enough teams and open enough culture, we may not fall for the same cognitive flaws.

Summary

As with confirmation bias and desirability bias, the “backfire effect” is important and can warp your interpretation of the world. Your political enemies and people you do not respect will not be the only victims of this. We can all fall prey to it and should be most sceptical of our views which are most closely linked to our core values and beliefs.

 

[1] http://www.breitbart.com/big-government/2017/07/16/just-nine-percent-republicans-think-trump-russia-collusion-abc-wash-post-poll/

[2] http://www.dartmouth.edu/~nyhan/nyhan-reifler.pdf

[3] http://timharford.com/2017/03/the-problem-with-facts/

Desire – Why use a stop-loss?

Once you realise how central desire is to processing information and making decisions, you can appreciate how important it is to be able to deal with it. Just being aware of your desires as we discussed in the previous article sometimes is not enough. The process of investment has a direct impact on your emotions and desires – “Fear and Greed” are well known but that does not make them easy to deal with.

If you are not careful, this will be your process

  • Belief leads to investment
  • The investment leads to the desire it will succeed
  • Desire leads to reinforced belief in the trade
  • The belief leads to confirmation bias
  • The confirmation bias leads to even stronger belief.

By this stage, your emotional ties have now blended with your beliefs

  • The risk is that you cannot process new information correctly
  • You do not get out of the trade when you should and lose money


Introducing the stop-loss

The cycle above is often why books on trading make stop-losses a central element. In fact they are ubiquitous in trading culture, as a hedge fund manager investors would often ask where my stop-loss is on a given position. The theory is clear:

“If you have a rigid and clear stop-loss, which you decide before you enter a trade, and then remain disciplined in sticking to it, then you are protecting yourself from your own inability to objectively evaluate the position after you have put it on.”

This is great advice for most investors. Another great piece of advice would be:

“DON’T TRADE – you aren’t any good at it and will lose money”

The books tend not to mention that one.

IS there an alternative?

A problem with a stop-loss is the trade might still be a great trade. In fact, it could be better or worse that when you initially traded. New information will have become available, but by pre-committing to get out of the trade, you are not able to do anything about it.

There are other ways to manage positions aside from stop-losses. I borrowed a helpful way to think about this problem from George Soros – please read “The Alchemy of Finance” – a truly wonderful book with some very important ideas. One of Soros’ key ideas is the application of Popper’s scientific method to investing. The application of hypothesis testing.

  • Key is not to start with a “belief” that the trade will work, in fact the trade is a test of the hypothesis that the trade will do well.
  • Analysis is therefore considering what would falsify this hypothesis.
  • Hypotheses are falsified all the time and it is nothing to get very excited about.

Therefore, desire is not engaged or at least minimised.

  • This willing suspension of belief is critical to being able to remain objective later.

What can falsify a hypothesis. For example

  • Fundamental news invalidating the underlying idea
  • Price action that tells me what I thought matters in this market, is not what really matters
  • Price action that tells me there is something going on I do not understand.

In practice, this can look very similar to a stop-loss, but It leaves the door open to more discretion and flexibility. For example:

  • Fundamentals have worsened while the price action is fine
    EXIT i.e. do not wait for the stop-loss
  • Fundamentals have improved while price action is poor
    Do not automatically exit as some of the most profitable opportunities from these times of material mispricing. Do more investigation.
    Possibly INCREASE the position size rather than cut it

Conclusion

Working with Soros, I observed that this process allows him to be enormously flexible. He does not seem to fall into the standard pitfall of emotional attachment to his trades. Instead fluidly cutting, increasing or reversing them when he changes his mind. This level of control and discipline sets him apart from the vast majority of traders I have seen.

Desire – The Fatal Flaw


“That’s the trouble with hope. It’s hard to resist.” The Doctor to Missy

Desire is everywhere

I introduced the link between desire and beliefs in my last post.  As humans, this is how our brains are wired. A way to think about the human thought process is this:

Picture1

Desire is dangerous and hard to resist

Recently, we have witnessed desires replacing beliefs as the central element of the political discourse. The recent Brexit campaign was perhaps the ultimate triumph, as the debate centred on deep seated desires “Do you want to leave the EU?”

The Leave campaign focused on stirring powerful emotions, whereas the Remain campaign had no emotional resonance, relying upon things no-one cares about such as economics and facts! The level of debate was astonishingly poor because it was not really a debate at all. It was an emotional primal scream and clear evidence that desire leaves beliefs trailing in the dust.


How to combat desire

One of the ways that I combat the power of desire is to try to become consciously aware of it. If I have a belief, I try to work out if it matches with my desires. If so, I may be prone to desirability bias and note it as something to be wary, of as we mentioned in the previous piece. This is especially important for doing fundamental analysis for trading, where is can easily influence my decision-making process.

Let’s use some recent examples:

  • I remind myself to tone down the potential importance of anti-Trump developments

I read Fox News and the NY Times,
I watch John Oliver and …. OK I cannot watch Fox and Friends

  • I read the Telegraph every day during the Brexit campaign

If my belief does not match any desire I have then I note that while I might still be wrong it is unlikely this type of error. For example

  • I do not want the UK economy to be wrecked, but I think that Brexit might do it.
  • I have no particular love for the EU, but I think Brexit is a disaster.

This means that my belief that Brexit is a disaster likely comes from my analysis rather than by analysis being driven by my desires. I still have to consider other ways in which I might be wrong but eliminating the really disastrous one is the most important.

  • I would prefer that the US equity market were very cheap

So my analysis that it is expensive is disappointing but likely not driven by a desire.

Desire is a particular problem for investors

Investors are particularly vulnerable to these problems of desires influencing beliefs.
Given that our beliefs on the market require frequent updating based upon new information, any cognitive error in processing such information can often lead to poor decisions and emotion taking over. The related but more important problem is our desires as investors are not independent from the act of investing. The very act of making an investment changes our desires.

Let’s use an example is have used many times in the past 25 years.

Imagine I take you to a racetrack.
There is a race coming up and I ask you which horse you think will win.
You do not know much about the horses and so have no view independent of the odds you can see posted.
I give you £10k and say you have to put it on a horse that is 5-1. If you win you get to keep the winnings.

Now you care.
You are going to have £50k in your pocket if your horse comes in and nothing if it loses.

What do you think happens during the race? I bet you get pretty excited. When your horse is edging in front with 2 furlongs to go you are jumping up and down with excitement and are convinced you are going to be rich.

I offer to pay you £10k now to cancel the bet. You look at me as though I am crazy or trying to steal from you as you are about to win £50k. you are very confident.

Your horse tires and comes in sixth. Your horse is a well-known front-runner who tires badly. But you did not seek out that information and are shocked and deflated.

But it was pretty exciting and you can’t wait to do it again.

Conclusion

If you do not combat it what you want to believe will have a dominant impact on what you end up believing to be true. If you sit inside your bubble only listening to people you like and respect then you may be falling prey to Desire.

Decision making – systematic flaws & biases

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:

Capture

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:

  1. If our desires and beliefs are aligned
    Confirmation bias will be even stronger.
  2. 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.