Wednesday, July 16, 2008

Confirmatory Bias and Oil Investing - Part One

I recently came across a post on the Victor Niederhoffer Blog about the concept of Confirmatory Bias. I shall reprint the standard quote from Sir Francis Bacon that is used in much of the literature on this subject:

"The human understanding when it has once adopted an opinion (either as being the received opinion or as being agreeable to itself) draws all things else to support and agree with it. And though there be a greater number and weight of instances to be found on the other side, yet these it either neglects and despises, or else by some distinction sets aside and rejects; in order that by this great and pernicious predetermination the authority of its former conclusions may remain inviolate..."

After searching further, I came across a paper published in the Review of General Psychology in 1998 authored by Raymond S. Nickerson of Tufts University. I believe that the concepts he discusses have applicability to current beliefs by bullish energy investors about Oil.

Nickerson presents a modern definition of the concept of Confirmatory Bias;

"...the seeking or interpreting of evidence in ways that are partial to existing beliefs, expectations, or a hypothesis in hand."

In his paper he reduces the concept to its component parts. I will discuss four of them, and then present my own.

Number 1 - Restriction of attention to a favored hypothesis.

"If one entertains only a single possible explanation of some event or phenomenon, one precludes the possibility of interpreting data as supportive of any alternative explanation."

Oil bulls believe that the only thing that can explain high oil prices is the trite hypothesis currently circulating in the market - that strong demand from emerging economies and limited, or even peak supply, is responsible. All other evidence to the contrary is ignored. The possibility that "speculators" or "traders" or "momentum players" may be partly responsible for a premium is scorned.

This belief, of course, ignores 220 years of history in the American financial markets, where there have been many cases of market speculation and/or manipulation, from Erie Canal bonds to Railroad bonds to Internet stocks. The real question that one should ask is the inverse of this - is there any financial instrument and/or Commodity that hasn't been subject to speculation or manipulation or overvaluation?

Number 2 - Preferential treatment of evidence supporting existing beliefs.

"...the tendency to give greater weight to information that is supportive of existing beliefs or opinions than to information that runs counter to them. This does not necessarily mean completely ignoring the counter indicative information but means being less receptive to it..."

This is seen regularly in any statistical report issued regarding oil. If the Department of Energy (DOE) or the International Agency Energy (IEA) comes out with any report that challenges the bull - the report is "bad data." Any statistics that support the bull is trumpeted for the world to see, thus proving the investment case.

If economic activity in the U.S. and other OECD nations slows down, leading to less demand for oil, it doesn't matter, as long as demand in China continues to grow at its absolute number of 500 thousand barrels a day. The fact that a 2% contraction in oil demand by the OECD would be twice China's absolute growth is not given any weight by the market.

I will present Part 2 tomorrow.

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