Do you believe in magic? I don’t, but I sure do enjoy a good magic show. Not only are the theatrics fun, but I like trying to figure out how the magician performed his trick.
However, magicians wouldn’t be selling out shows in Las Vegas if folks weren’t willing to suspend reality for a bit and believe that the woman was cut in half; the man can levitate; a live rabbit was pulled out of a hat.
One of the most famous magicians of all time, David Copperfield, was forced to reveal the secret behind one of his most famous illusions, Lucky 13, in 2018.
For those who don’t know, Lucky 13 is when 13 audience members are randomly selected and pulled up onto the stage. A giant curtain is flung over the stage, and when it’s lifted David Copperfield reveals that those 13 audience members had disappeared, only for them to reappear at the back of the room.
David Copperfield got into some legal trouble when an audience member involved in the trick got hurt, and was forced to reveal the secret to Lucky 13 in court. Basically, after the curtain fell the audience members were led through passageways that go around the Las Vegas MGM building, so they could exit and re-enter at the back of the stage.
When you boil down to it, this trick was really just some misdirection, fancy showmanship, a secret passageway and a bit of a walk.
And yet, this was one of David Copperfield’s most popular tricks. We know teleportation isn’t possible, and yet, even for just that moment or two, folks believed it was. We would rather support the notion that David Copperfield can bend the laws of nature and teleport people because the real reason is far less entertaining – it was an illusion.
Why? Because of confirmation bias. This is a phenomenon where decision makers actively seek out and assign more weight to evidence that confirms their hypothesis, and ignore or underweigh the evidence that could disconfirm their hypothesis.
But the reality is that confirmation bias happens a whole lot more outside of a magic show. In fact, it even shows up in everyday investing. That’s why so many of us turn to stock picking systems, like my “Quantum A” philosophy, to weed out terrible investments and find the great winners.
So, in today’s essay, we’re going to talk about the financial bias, and how I can help you from making the same mistake that so many other investors do. Let’s get to it!
Why We Do Silly Things
Over the past 40 years, our understanding of why people do the things they do has grown by leaps and bounds.
By performing an enormous amount of experimentation, psychologists and economists have created what we now call Behavior Finance.
Why do we hold onto losing stocks when our rationale for buying the stocks is gone?
Why do we sell winning stocks way too quickly?
Why do we resist making smart financial moves when we can easily see how beneficial they will be?
Why do we act so crazy with money?
Behavior Finance attempts to answer all those questions and more. While it would take hundreds of pages to thoroughly explain the origins and theories of Behavior Finance, I’ll sum up some of its most useful findings below. As you’ll see, we know now that human “biases” often torpedo our investment performance.
Here are some of the most common, most harmful ones:
Anchoring or Confirmation Bias: We like to have our opinions confirmed by others, especially so-called experts. Because of this, we will search and find information, data and analysis that will confirm our opinion. If you want to see this bias in action magnified, talk to someone who is bearish on stock prices. They will cite chapter and verse of all the doom and gloom columnists who share their opinion and drag out charts, graphs and slide shows that clearly demonstrate how and why the world is going to end. They have their opinion, and it’s confirmed by others. Any evidence to the contrary will be ignored.
Gambler’s Fallacy: There is a tendency among people to think that when a coin has been tossed five times and it lands on heads five times it is much more likely to land on tails the next time. This is totally incorrect. The odds of it being tails are exactly what they were the first five times: fifty-fifty. Each flip occurs separately and independently of the others. It doesn’t have to land on tails. And just because the market has been up or down the past several days doesn’t necessarily mean it has to do anything one way or the other.
Hindsight Theory: When we look back over history, we tell ourselves that we knew something was going to happen before it did. The Internet bubble that burst in 2001 is a powerful example. Everyone now claims that they saw it coming. They just knew that the market had reached unsustainable highs and that the bubble would burst and take all the high-risk investors and day traders to the cleaners. So if everyone knew in advance, then how come they all lost money? Almost no one admits that they hung around for the whole ride and lost money in the meltdown, yet millions of people lost billions of dollars in that time frame.
Rearview-mirror Effect: We tend to be most influenced by what has happened recently instead of what is happening right now. As the market goes higher, individuals (and institutions – after all, mutual funds and hedge funds are run by humans) tend to become more and more bullish; when the market has sold off for an extended period, they become more and more reluctant to buy.
Self-attribution Bias: We have a tendency to congratulate ourselves for our own brilliance when we succeed, but blame outside influences for our failures. When a stock we picked goes up, it is because we are clever and made the right choice. When a stock we picked goes down, it’s the economy, the Federal Reserve, the stupid broker or those gosh-darned hedge funds that made things go wrong. In my office, we refer to this as confusing a “bull market for brains.”
Disposition Effect Bias: One of the worst tendencies of investors is to sell winners far too soon and hold on to losing stocks. The old saying, that you can’t go broke taking a profit, has killed more investor portfolios than Attila the Hun did Romans. If you take 5% to 10% profits on your winners but continually take huge losses on your losers, holding onto belief that it will come back, your overall results will look pretty bleak. The flip side of selling winners too soon is just as dangerous. I call it “falling in love.” You can show love to stocks, but stocks can’t love you back. When they become too risk, you simply have to sell them and move on, even if they have made you rich.
Familiarity Bias: This happens when an investor focuses on familiar or well-known investments even though more gains can be made through diversification. As a result, this can lead to poor-performing portfolios and a greater risk of losses.
Trend-chasing Bias: Past performance does not indicate future success. So, just because a company did well in the past does not mean that that trend will continue.
As a card carrying member of the human race, I’m not thrilled to report that our brains are such terrible investment tools. It’s like we have computers that occasionally won’t turn on… that have flickering screens… and that completely shut down right in the middle of a task without saving our work.
That’s the bad news.
The good news is that just like machines have helped us grow enough crops to feed the world… just like machines allow us to light and heat our homes… and just like machines save us all types of backbreaking labor… machines can massively improve our investment performance.
I’m talking about better investing made possible by computing power.
How to Put the Evidence to Work for You
Our ancestors believed in things we now know to be completely wrong. People believed angry gods created crop failures. Livestock died because someone forgot to make the right sacrifice in the right temple.
The reality is, short of hard science, we invent reasons for the things that happen in our world. This tendency to believe in the magical takes place every day on Wall Street. Analysts make claims such as, “The stock was going to be fine but it ran into a double top chart pattern that caused it to break down.” More on the fundamental side, we hear things like, “Well, the FDA just refused to see the benefits of the miracle cancer drug.”
I’m a numbers guy. Numbers and stocks are two of my greatest passions in life. Fortunately, I’ve been able to combine them into a long and successful career picking growth stocks. I believe that the proof is in the numbers and that analyzing the numbers can help us find stocks with huge growth potential without the pitfalls of human bias.
It was pure numbers-based research that led my firm to sell tech highflyers Cisco and Sun Microsystems in 2000. Others stubbornly held on to the tech story and stayed long after the party had ended; they lost big. It was pure numbers-based research that had us buying homebuilders in 2002, just as they began a huge multi-year run higher.
More and more, society is understanding that it is often numbers that have the most meaning in things like business, sports, and health. Meaningful, real answers, as opposed to mysterious forces and superstitions, come from scientific analysis of the numbers underlying a situation.
Ignoring the numbers, and analyzing things from a “gut feel” point of view, allows us to color situations with our own hopes, biases, dreams, and opinions. Plus, there is just too much information of a subjective nature floating around us every day.
Malcolm Gladwell pointed out a great example of this in his book Blink. He detailed how a new, simple mathematical algorithm helped emergency room doctors quickly and simply assess whether a patient was having a heart attack. Researchers discovered that doctors had too much information coming at them too fast, so boiling it all down to a simple formula sped up the process, made it more efficient, and saved lives.
The use of statistical analysis has also spread to the sports world. In his bestseller Moneyball, Michael Lewis tells the story of Billy Beane, who managed the Oakland Athletics baseball team. Beane is considered one of the game’s true innovators because he relied on statistical analysis to make key decisions. Beane developed formulas to measure a player’s statistics against the cost of the player’s contracts. Using the numbers, Beane turned the Athletics into one of the winningest teams in baseball with a fraction of the cost of big money teams like the Yankees.
Numbers-based analysis is also widely used by law enforcement to crack cases, by insurance companies to assign different rates to different drivers in different locations, and even by casinos to separate gamblers from their money.
So, if statistical analysis and evidence-based thinking works so well in so many other areas of life, why wouldn’t it work in the stock market?
The fact is that it does.
As I mentioned, one of the key aspects of using numbers and evidence to guide our decision making is that it helps keep human bias from our investments.
Because of my reliance on the numbers, my firm is one of the few investors who can claim to have made a substantial amount of money in Enron.
Everyone now knows the Enron story… how its accounting and trading frauds bankrupted the company. What people forget is that Enron was once a powerful growth company with rapidly rising sales and earnings.
We were in the stock while it was in high growth mode but exited it long before the bad headlines hit because our analysis of its financials revealed weakening fundamentals and increased risk. We didn’t know the backstory. We didn’t have to. The numbers told us to get out well before the newspapers reported the bad news.
However, Wall Street maintained its bullishness on the stock because of human bias. Analysts got caught up in the Enron hype… the magazine covers… the fawning headlines. But our numbers didn’t care about all that. They simply showed the business was starting to struggle and we took our gains off the table. Thanks to my “Quantum A” method of buying and selling stocks, we got out with a solid profit WAY before the stock went to zero.
What Computers Won’t Do to Your Performance
Think back to the days when you didn’t perform your best at work.
Maybe you were sick… or very tired…or distressed with a family situation… or hungover. Maybe something between you and a co-worker, employee, or boss upset you. Maybe you couldn’t wait to leave for vacation. Maybe you ate way too much at lunch and needed a nap.
There are a thousand reasons why we don’t perform our best. We’re humans. And that’s another point in favor of computerized investment analysis. Computers don’t call in sick. They don’t complain. They don’t request vacations. They don’t get into spats with co-workers. They don’t get distracted by family issues.
Computers will work for you 24 hours a day, 7 days a week. And they spot what you can’t — because you don’t have time for hours of research. Research the computer completes in a fraction of the time.
The bottom line is that all the characteristics and biases I mentioned…they’re just part of being human. When put into play in the stock market, they can lead to serious loss and damage to your net worth. I have not figured out how to stop being human, and I do not think you will be able to, either.
I know that I can be a sucker for a great story, or get lulled into a false sense of security, or believe my own hype, or even follow the herd, which is why I steer clear of it all when it comes to making money in stocks and instead stick with the numbers.
By focusing on the numbers and letting my software programs do the work, our profits can sometimes be downright magical – no tricks involved.
Ready to Put These Systems to Work?
I hope you enjoyed this special series and found it useful. We covered a lot over these past five days, including how I made 1,125% on a single stock… how I discovered one of the most powerful investment systems on earth… and the “iron law” of the market that allows us to get into big stock growth winners early.
I put all these practices to work in my Breakthrough Stocks service so my subscribers can buy into small- and mid-cap stocks that are set to breakout. I will be issuing new recommendations soon, so make sure to sign up here now so you don’t miss out on the hottest new “Quantum A” buys.