Confirmation Bias Is a Portfolio Killer

• Posted by kid dynamite
• on September 22nd, 2011

As markets continue to bubble, boil, roil and toil, I wanted to get back to two key concepts that I think are amongst the most important for successful investing and/or trading.

The first and foremost is avoiding confirmation bias.  I’ve written about this topic already, and I don’t have a ton to add, so I’ll just use the famous SELF-QUOTE technique:

“It’s a natural human tendency to seek out conforming opinions – people who agree with us.  It makes us feel “right” and good about our decisions.  In the investing world, however, this is dangerous.  When I form an investment thesis, I’m always trying to figure out why it’s WRONG, not why it’s RIGHT.    I want to know the thesis of the guy on the other side of the trade as me – and then I can evaluate whose thesis is stronger.  Ideally, I get comfortable with the thought process of the other side of the trade, can confidently debunk it, and gain confidence in my position.   More likely, I realize what I may have been missing, or understand how the data can be interpreted differently,  and learn what I need to keep an eye on while carrying out the trade.”

The second topic is an offshoot of Confirmation Bias, and I’ll use a trade I currently have on as an example.  A few weeks ago I put on a trade: long $GDX (gold miners) vs short $GLD (gold).  The thesis is that the miners’ price appreciation hasn’t kept up with gold’s price appreciation, and that this gap is likely to narrow at some point.  What worried me is that ever since I put the trade on, everyone seems to be talking about it.  Eric Sprott, the Wall Street Journal, various gold pundits: EVERYONE involved with the metals seems to love this trade (or its sister trade with SIL and SLV).

Now, if you’re guilty of confirmation bias, this might seem like good news to you – “yeah,  everyone agrees with me – I must be right.”  As I noted once in a previous post, crowd agreement is a hyper-dangerous sign in markets – almost always a contrarian sign.  As I put it last time, simply, “When everyone is bullish, there’s no one left to turn bullish and buy!”

Let’s look at a few charts behind this trade. If you look at a 6 month chart, or even a 2 year chart, you are likely to get the impression that the miners are relatively cheap – that is the impression that I got too, and one reason I put the trade on.  Here’s the 6 month chart:

Here’s the 2 year chart – STILL looks like it’s relatively cheap these days:

But I’m also well aware that this ratio can get much cheaper, so I didn’t ignore the chart that goes back to 2009, and shows that “cheap” can get “cheaper.”  More importantly, I understand that mean reversion to the higher “historic” levels is not a given here!

Today, of course, the miners are getting absolutely rocked relative to gold, underperforming by more than 4% as I type this (GDX down 6.44%, GLD down 2.39%).    If you want, you can make up “excuses,” like “hedge funds are manipulating mining shares lower.” or “high frequency traders are distorting prices.”  If that makes you feel better, then you’re not learning anything here:  focus on why this trade might not be everything you think it is,* understand that this is what happens to crowded trades (or equity markets in general) in panicky markets, and reevaluate your thesis.  That doesn’t mean you have to abandon your thesis, just make sure it’s still sound – don’t confirm it with excuses and blame, confirm it with research and sound theory.

While I’m on the topic, let me use gold and silver as an example one more time.  I have no doubt that if you read the metals blogs, you’ll read that today’s price action was a “massive criminal raid on the price of gold and silver.”  If you read that, accept it, and feel better, then you are a walking example of Confirmation Bias.  Gold and silver have become asset classes.  When global markets sell off, they get sold along with everything else.

-KD

disclosure: I am long $GDX vs short $GLD.  I also have Oct $GLD calls.

postscript – from an introspective point of view, one thing I find inexcusable for myself is that I’m not exactly sure what I want to happen on a macro scale to make the most of my long GDX vs short GLD trade… In other words, do I want a market crash?  Do I want an equity bull market?  Do I want the Fed to drop money from helicopters?  Do I want austerity?  I’m not even sure what I want to happen in order for this trade’s profit to be maximized, and I don’t think that’s a good thing…

* possible reasons that the trade isn’t working / might not work – in my opinion:

1) main reason: the miners have been reduced to peripheral bullion plays, and are no longer needed to serve the purpose of exposure to metals – we have pure plays now that make it easy to gain targeted direct exposure to gold, silver, platinum, palladium, and, soon, copper.  This is the main reason, and the most worrysome:  you can see that the ratio trend appears to be drifting lower: that’s not an insane outcome, if more investors look to protect themselves by getting gold exposure from pure play bullion instruments instead of mining stocks…

2) risk of mismanagement/bad management, political/national risks, etc.

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