Confirmation bias

Confirmation bias means giving greater weight to information that supports your view than information that does not. A trader who is bearish will take every little hickup in the market, every little event that occurs in some far-flung market. A bearish investor will read with great interest when a chartist puts out a bearish analysis based on some cyclical theory, even if at other times he would ignore such information completely, eschewing charts.

Likewise a trader who normally just acts on price action, but develops the view that a move is imminent, will keep an ear out for any piece of information that supports this view, even if his normal policy is to ignore news and rumours and trade the trends.

In short, confirmation bias means listening intently to anyone that agrees with you, however nutty you think they are under normal circumstances, but rejecting anything that doesn't agree with you. This is paired with another tendency people have to not ask themselves any questions that may challenge their own preconceptions.

As a personal example, several years ago when I was a little younger and a little less wise, I became quite set on the idea that the market was about to crash. So sure was I of the imminent demise of stocks that I actually went out and bought a put option on the index. At this time I was already well aware of time decay and the intrinsic value of the option, I also had been trading stocks for a while before then, in fact due to the bull market and a serious dose of beginner's luck I had not yet had the experience of having a stock I bought fall in value. This by itself is a very dangerous thing, he who can do no wrong usually thinks risk management doesn't apply to him. I had picked the previous few market tops and bottoms in the All Ordinaries with startling accuracy, and was quite good (or lucky) at picking turning points in stocks as well. (For the record, I was using Elliott Wave).

I made a series of psychological blunders over this. First of all I made my bearish views known in aus.invest. This was really silly of me. Not only did it make me a target of much ridicule every time the market went up a bit, but also the target of blame for anyone that decided to sell on such advice. Nothing anchors a view more firmly in one's mind than being on public record having made a statement. As I have found out a few times, there seem to be many people out there who delight in searching the news archives to find material to quote to hound you with later.

aus.invest neatly split in two, several threads ran over many weeks devoted only to the topic of whether or not I was right. While I was surprised by the hostility by some members, I was encouraged by various people making other bearish posts in support, citing the general over-valuation of share prices, various analogues to previous crashes and a number of financial crises that were playing themselves out at that time.

Not only these bearish posts, but my own analysis helped stoke my bearishness. At the time I was experimenting with Gann methods, and found that several Gann turning points were occurring at that point, a sign that the market was about to do something. Now if ever there was a classic case of confirmation bias acting on someone it was me taking comfort from a Gann square! At that time the Elliott Wave sequence was very unclear, I had predicted the end of the bull market and the correction had clearly arrived, but it was impossible to figure out what was happening next. Someone purely trading Elliott Wave would have most likely sold some of their riskier stocks but there was no immediate cause to think the market was going to fall in that particular day, week or month. I should have stuck to my method and realised that there was great uncertainty, but hey, I had made up my mind by that time and if my new Gann spreadsheet was showing a reversal, that was great!

(Just in case anyone is wondering how this bearish call worked out, it was a few weeks too early, not long after all this the market did fall sharply, but soon recovered and the Dow industrials broke through 10,000 and then 11,000 for the first time. My put at first showed a nice profit, but I foolishly held on until the put became so cheap it wasn't worth the brokerage to sell out. Note long afterward of course the NASDAQ broke down and the Tech Wreck occurred, the Dow Jones began its own fall, and has been in a bear market ever since.)

A trader who short sold NASDAQ futures would have done extremely well out of this call, and any investor who sold his stocks would also now be glad he had. I sold most of my stocks, but I didn't sell short an index. My put warrant, on the All Ordinaries index expired worthless because the market took too long to start to fall, and when it did it was a rather solid decline, as opposed to a sharp and brutal 1929 sort of deal, which is what I was anticipating. (All Elliott guys are just hanging out for another 1929, because when it happens all the Elliott gurus who have written books predicting this for the better part of three decades will finally be able to say they were right)).

Even as I was in this trade I already had a serious nagging doubt about the upcoming crash. Apart from anything else I was already into contrarian investment and at that time large numbers of gurus were predicting a crash. My contrarian viewpoint was that with such overwhelmingly bearish traders the market could only explode upward, at least for the short term. I knew markets were overvalued (particularly the NASDAQ) but I felt that although my own analysis showed a bear market, I realise that in general when the herd has made up its mind one does better by doing the opposite. A couple of weeks later with the Dow at 11,000 I would have had the perfect selling opportunity because although I was as bearish as ever, traders by now were encouraged by the recent gains and were all bulls.

Isn't hindsight wonderful?

My one consolation is that I had the sense to put very little money into this option position and did not hurt me financially for long.

There are a few lessons from this:

• Don't ever get so attached to a view that you become blind to the fact that you may well be wrong.

• Don't ever place yourself in a position (by posting to aus.invest, or other means) where it becomes a matter of being proven right or wrong and potentially being embarrassed by changing your mind. You have nothing to prove to anyone.

• Just because a method agrees with you does not mean the method is correct, nor does the output of an otherwise dodgy method mean anything at all, even if that method backs you up on something.

• There is no certainty. If you feel certain about something, write out 100 times that you do not know any better than the vast majority of market participants what is going on, you don't have as big an edge as you think you do, and you may well be in for a lesson in humility sooner than you think.

• Just because you think the Dow and the NASDAQ are going to fall, doesn't mean the Australian market will.

• Put options depend on more than just a falling market, you need to get the timing just right because if things work out more slowly than you thought they might the option will decay very quickly when it ends up far out of the money with only a short time to go. Volume in the option will also diminish to nothing meaning you couldn't sell out even if you wanted to.

• The proper course of action will be obvious with hindsight and you will berate yourself at your stupidity for missing such obvious cues.

An author who seems to offer some good insights into how to get around these sorts of biases is none other than Edward de Bono. His books talk about writing down your thought process in a "Plus/Minus/Interesting" format. If you write down all the bearish data and all the bullish data and all the "interesting" data, then you find that it has come out "wrong" on the paper, you have just identified a bias in your own view. Few traders talk about de Bono, but I think he is probably one of the ideal authors to psychologically prepare you for trading and investment.