Wednesday, July 23, 2008

Confirmatory Bias and Oil Investing - Part Three

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 in the oil market.

He 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 have already discussed the first two parts last week, and parts three and four here.

Today I present my own concepts. They don't really come under the strict definition of Confirmatory Bias, but they are certainly biases that support the bubble, and after all, its my blog and if I want to write about them I will.

Glorification of results or the market must be right.

Oil and Energy has been in a multi year bull market and if there is one thing I have noticed in investing, it is the presumption that because the "market" says something, then the "market" must be right. This is a situation where the "psychological high" that accompanies good investment results is substituted by investors for thorough analytical thought.

Commodities are up 50% this year, well there must be something to it. "These guys must know what they are doing, I guess I'm just not smart enough to figure it out," an investor mumbles under his breath as he heads to his broker, bitter about missing out on the good times.

I can find quotes to apply to other bubbles as well. How about this one for the Housing Bubble. "My neighbor owns five houses and flipped three last year, why can't I do the same? Home prices never go down so what do I have to worry about."

The Cheerleader Effect or talking heads on TV as the second coming of Jesus

Investors are constantly bombarded with information in support of the bull from talking heads on Television, either from professional investors, or from sell side analysts, the great facilitators of the bull market whose job it is to hold our hands while we continue our journey through commodity investing. All of these people have vested financial interests in the bull, and although this is disclosed, usually at the conclusion of the appearance, I don't think that it is generally understood.

This positive reinforcement has a huge unconscious effect on investors. I think that being on television somehow leads to this aura of omniscience that filters down to investors who watch them. Is it that hard to get on television? I don't know - they do need a constant flow of material to entertain us with.

What I do know is that sometimes it is hard to take what they say seriously when two weeks earlier, I saw the same guy during a conference, trying to fondle an 18 year old stripper who was bouncing around on his lap during the evening entertainment hour. Incidents like that tend to dissipate any aura around them in my eyes. These people are not Gods, they are not divine and they did not spring from the head of Zeus.

Investors will usually deny this effect, which can be subtitled "cult investing," but if you read between the lines you will see it is true. These analysts and pundits let you down before when it came to Internet stocks, and they let you down when it came to Real Estate. Are you going to believe them this time? Remember, Growth always disappoints in the end.

The misinterpretation of information usually by twisting it intentionally.

There is an entire cottage industry of analysts and talking heads whose job it is to manage and shape investors thoughts. If, God forbid, any bearish or contrary ideas begin to bubble up to the surface, it is their job to squash it in its womb, so nothing will impede the march of the Bull. As contradictory and bearish evidence begins to mount during the late part of a cycle, this becomes more and more difficult to do. This is the Wall Street equivalent of "spin control" in politics. Here is an example:

China and other Asian countries have partially removed subsidies on products refined from Oil, and sold to its citizens, many of whom have been shielded from the soaring cost of oil, and the resulting soaring cost of gasoline. So common sense would tell you that as the price of gasoline and other products go up, people should use less of it thus reducing demand. While this demand response tends to be closer to inelastic than elastic in the short term, there is an effect. Anyone who doubts this should look at highway miles driven in the United States the last three months.

Somehow this negative data point has been ridiculously twisted to instead mean that Asian countries will actually import more oil to refine into product because they can now lose less money than before, since they can charge more. So here's how it really works - if you sell 5 million gallons of gas and lose 50 cents a gallon you have lost $2.5 million. If you sell 10 million gallons and lose only 25 cents a gallon, well guess what, you've lost the same thing.

This reminds me of an old story that my father used to tell me. He worked in the garment or "schmata" business. After reviewing a new line of clothes, it was determined that to sell them at a competitive price, they would lose money on every piece they sold. The executive just leaned back in his chair, smiled and said, "don't worry, we'll make it up on volume."

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