In the world of purely efficient markets, economic actors behave in their own rational self interest by dispassionately weighing the evidence and making optimal decisions on investment matters. In the real world, emotions are often an investor’s worst enemy and typically lead to decisions that are suboptimal at best. One of the benefits of developing the “latticework of mental models” advocated by Charlie Munger and others is that we can begin to build defenses against human tendencies that lead to poor results.
“Defender of the Idea”
Michael Lewis, the famous author of Liar’s Poker, recently published The Big Short: Inside the Doomsday Machine which chronicles the subprime crisis that nearly led to the downfall of our financial system in 2008. A Vanity Fair excerpt of the book highlights the story of Michael Burry, one of the investors Mr. Lewis profiles in the book. Mr. Burry was one of the few investors who was able to predict the subprime mortgage crisis and took the initiative to buy credit default swaps that ended up being highly profitable.
Here is an excerpt from the book where Mr. Burry comments on why he dislikes debating his investment positions, particularly related to the credit default swaps:
Inadvertently, he’d opened up a debate with his own investors, which he counted among his least favorite activities. “I hated discussing ideas with investors,” he said, “because I then become a Defender of the Idea, and that influences your thought process.” Once you became an idea’s defender, you had a harder time changing your mind about it.
Mr. Burry is referring to commitment bias which causes individuals to become more convinced of their position once it has been publicly explained or debated with others. Along with confirmation bias, commitment bias is possibly one of the most dangerous pitfalls that investors can encounter.
Public Commitment Isn’t All Bad …
One interesting observation is that public declarations of commitment are not always bad either in life or in the field of investing. In many cases, making your case for an investment in a public forum may actually reduce the chances of falling victim to an impulsive decision at a later point when temporary factors create adversity. For example, if an investor has purchased a stock and written up his investment rationale in a letter to investors, a blog post, or a public message board, it would be embarrassing to reverse course unless some aspect of the original thesis no longer held true. For example, if one purchases Coca Cola based on the long term projection of beverage consumption, it would be inconsistent to sell the shares simply because the Federal Reserve raises interest rates.
While many investors have enough self control to avoid making impulsive or irrational decisions regardless of whether they have taken a public stand, other investors who are more susceptible to impulsive decisions may actually benefit from public commitments that could keep them on course in difficult situations.
Problems Arise For the Stubborn …
The problem with commitment bias comes when the individual is unable to admit a mistake due to a prior commitment or statement even when the facts clearly change. All investment decisions should be carefully documented when a position is initiated and then reviewed on a periodic basis to ensure that the underlying reasons for owning a security have not changed or that fair value has not been reached. Even the best investors occasionally make mistakes in which the original thesis that led to an investment prove to be incorrect. In such a situation, the investor must be willing to admit the mistake and move on.
The type of commitment bias that can be very harmful occurs when one cannot admit a mistake after a public position has been taken. The stronger the position, the more difficult it would be to admit a mistake. Even worse, when the level of commitment is high, the psychological tendency of confirmation bias may lead the investor to look anywhere and everywhere for a shred of data confirming the original thesis even if contrary evidence is overwhelming.
Dealing with Commitment Bias
How can an investor defend against commitment bias? There appear to be two ways: First, one can avoid any public declarations associated with investments. This reduces the bias but does not eliminate it because the individual still may be internally impacted by his prior decision (it is often very difficult to admit a mistake to yourself). Second, the investor who takes a public stand can reduce the risk of commitment bias by being explicitly aware of this tendency and seeking out contrary information on a routine basis.
While each individual is different, it seems like the second option is the more healthy approach particularly because seeking out contrary information and being willing to admit errors is generally a good practice when it comes to making intelligent investment decisions.
For those interested in an extended discussion of commitment bias, please refer to Chapter 3 of Influence: The Psychology of Persuasion by Robert Cialdini.