Investing Basics: Avoiding Confirmation Bias

I am reading the excellent book, "The Little Book of Behavioral Investing" by James Montier. In this book, he talks about pitfalls every human encounters when making decisions when there is either a) insufficient information b) the problem is complex or ill-structured c) the goal is not well defined d) high stress/high stakes e) decision relies on interaction with others.

We recognize that investing has each of these characteristics and to become a better investor we need to learn how to control our baser instincts. Sometimes, it is near impossible to do so unless you know the pitfalls.

The pitfall that caught my eye is confirmation bias. I have succumbed to this more often than I would like and the reason was that I never realized that I am doing it.

Confirmation bias is the tendency to favor information that confirms our belief or hypothesis. This means that you ignore information which does not sit well with what you think, remember information selectively or interpret it in a biased way. You fall to confirmation bias when you do these things (it is easy to come up with more elements on this list):
You think that a company is cheap, so you Google for articles that have a buy recommendation. Or you look for reports by analysts who think that the stock is going to go up.You flock to the club your views agree with and shun those which have a different tone. For example, value investors ignoring momentum investors because they think that the momentum investing is somehow beneath them or is clearly not "investment." Even less drastic is value investing vs dividend investing. If you look at the people who are into dividend investing, they like to read/talk to people who are into dividend investing too and vice versa.Ignoring information that is counter to your thesis. You may justify the information by saying that this is an anomaly and will not happen again (say when a company reports bad earnings for a quarter). You can choose to justify a second bad earning in the next quart! er as an extended bad spell and a time to buy further, ignoring the warnings of people who clearly do not fit your view of the world.Democrats reading NY times and watching MSNBC and Republicans doing the same thing with Wall Street Journal and Fox News.When you think a stock is cheap and it jumps 10-20% in a week or so, you like it more and maybe buy it, if it drops again.
Montier describes a simple yet ingenious test to show this bias in practice.

Imagine you are faced with the following sequence of numbers: 2-4-6. Your job is to figure out the rule I used to construct this sequence. To uncover the rule you may construct other sets of three numbers and I will give you a feedback as to whether they satisfy the rule I used. If you are sure you have the solution, you may stop testing and tell me what you think the rule is.
Given this test, most people let their emotional side of the brain take over. They ask for a feedback on 4-6-8 and say 100-102-104 and when the answer for both of them is affirmative, they stop and say "any numbers that increase in increments of two."

This is the wrong solution as the rule was "any ascending number sequence." Can you recognize the confirmation bias here? As soon as you see the sequence 2-4-6 you come up with the hypothesis that this is a sequence where each consecutive number is an increment of 2 from the previous one. You test your hypothesis by polling for sequences which fit your hypothesis.

This is clearly the wrong way to go about it. To test a hypothesis, it is best to look for information that disagrees with the hypothesis and not information that agrees with it. To explain it better, I will describe another experiment where you see it more clearly.

Let us suppose that after investing a significant amount of time you come up with a winning formula for investing (there is one by Joel Greenblatt, for example). The formula is quite simple and says that if some conditions are true then the stock will double in three years. Now! , how do ! you test if your formula works? Let us consider these three options:
You look at stocks that satisfied your formula and doubled within three years.You look at stocks which doubled within three years and verified that your formula holds true for them.You look at stocks that satisfy your formula and did not double within three years.
The general tendency is to check 1) and maybe 2) (which you will probably notice what most analysts and sometimes book writers do). But clearly the test for this formula is 3). If you find a company that satisfied your formula but did not double then obviously your formula does not work. It does not matter if your formula works on thousands of stocks! If it fails on one then it is not true.

Karl Popper, an English philosopher, observed that the only way to test a hypothesis is to look for all the information that disagrees with it. This process is called falsification.

The question now is: Can the confirmation bias be sidestepped? The first step towards this actually is to step back from your decision and recognize that it suffers from confirmation bias. For example, suppose Vivendi was on your watchlist for stocks to buy if it dropped below €11. A few days back you read that Seth Klarman bought shares. You have read Klarman's "Margin of Safety" and have seen his track record. You think that if it is good enough for Klarman in terms of return, it is good enough for you. Note that you have done your due diligence before putting the company in your watchlist and you are not blindly following Klarman.

This still is confirmation bias. You must have come up with a margin of safety calculation and had felt that €11 is the cutoff price given your investment goals. Recognizing that this is the case is half the battle. Once you recognize that you are suffering from confirmation bias, you should start with a clean slate. Ignore that Klarman bought shares. Re-evaluate the company and see if it makes sense to invest at the current price.

A good examp! le is als! o (as Montier points out) the checklist by Bruce Berkowitz on killing the company. Think of all the things that can go wrong with your investment. If you still can't kill the company and there is a sufficient margin of safety, only then you should make an investment decision.

Carnival Stays Underperform - Analyst Blog

We remain Underperform on cruise operator Carnival Corp. (CCL), given its mixed second-quarter fiscal 2013 results, successive slash in guidance, and lingering European crisis.

Why the Reiteration?

Although Carnival's second-quarter fiscal 2013 adjusted earnings beat the Zacks Consensus Estimate by 50%, its revenues missed the same. Both earnings per share and revenues slipped year over year. A lower net revenue yield owing to reduced pricing led to the decline in revenues, which when combined with higher cruise costs marred earnings.

Moreover, Carnival is facing one ordeal after another. After the grounding of its ship, Costa Concordia, in Italy in Jan 2012, the engine of its Triumph cruise ship caught fire in Feb 2013, which hurt the company's fiscal 2013 guidance. Even though the company is recovering at a slow but steady pace from the Concordia grounding disaster, it continues to be a cause of concern for the company.

Lower bookings, voyage cancellations and higher costs compelled Carnival to trim its fiscal 2013 earnings guidance twice in a span of six months. Earnings for fiscal 2013 are now expected to remain in the range of $1.45—$1.65 versus $1.80—$2.10 per share expected earlier (announced in May 2013).

Prior to this, Carnival reduced its earnings guidance from the range of $2.20−$2.40 to $1.80–$2.10 per share. Consecutive cuts in earnings guidance within a span of six months raised concerns about the near-term outlook of the company.

Last but not least, Carnival's European operations will prove to be challenging even in fiscal 2013 due to the sovereign debt crisis, which has lowered consumer spending. On the pricing front, EAA (Europe, Australia & Asia) witnessed softer trends even before Costa was grounded.

Apart from pricing, overall occupancy and booking volume are also expected to remain low for European cruises for the rest of 2013. Carnival currently retains a Zacks Rank #5 (strong Sell).

Others Stocks to Co! nsider

Players in the leisure and recreational industry, which look attractive at current levels, include Ambassadors Group Inc. (EPAX), International Speedway Corp. (ISCA) and Norwegian Cruise Line Holdings Ltd. (NCLH), all carrying a Zacks Rank #2 (Buy).

2 Basic Materials Stocks With Big Volume to Watch

DELAFIELD, Wis. (Stockpickr) -- Professional traders running mutual funds and hedge funds don't just look at a stock's price moves; they also track big changes in volume activity. Often when above-average volume moves into an equity, it precedes a large spike in volatility.

Major moves in volume can signal unusual activity, such as insider buying or selling -- or buying or selling by "superinvestors."

Unusual volume can also be a major signal that hedge funds and momentum traders are piling into a stock ahead of a catalyst. These types of traders like to get in well before a large spike, so it's always a smart move to monitor unusual volume. That said, remember to combine trend and price action with unusual volume. Put them all together to help you decipher the next big trend for any stock.

With that in mind, let's take a look at several stocks rising on unusual volume today.

Energy Transfer Equity

Energy Transfer Equity (ETE) owns and operates natural gas gathering systems, natural gas intrastate pipeline systems and gas processing plants. This stock closed up 1.8% at $66.21 in Wednesday's trading session.

Wednesday's Volume: 4.58 million

Three-Month Average Volume: 1.28 million

Volume % Change: 321%

From a technical perspective, ETE spiked higher here right off some near-term support at $63.90 with heavy upside volume. This move pushed shares of ETE into new 52-week high territory, since the stock took out some resistance at $66.97. At last check, ETE hit an intraday high of $67.90 with volume that was substantially above its three-month average action of 1.28 million shares.

Traders should now look for long-biased trades in ETE as long as it's trending above support at $63.90 or above more support at $62 and then once it sustains a move or close above its new 52-week high at $67.90 with volume that's near or above 1.28 million shares. If we get that move soon, then ETE will set up to enter new 52-week-high territory, which is bullish technical price action. Some possible upside targets off that move are $70 to $75.

USEC

USEC (USU) is a global energy company, which is a supplier of low enriched uranium for commercial nuclear power plants. This stock closed up 3.9% at $18.31 in Wednesday's trading session.

Wednesday's Volume: 1.02 million

Three-Month Average Volume: 512,580

Volume % Change: 172%

From a technical perspective, USU bounced sharply higher here right above some near-term support at $16.11 with strong upside volume. This stock recently pulled back sharply from $29.12 to $15.05 with heavy downside volume flows. Following that pullback, shares of USU have started to stabilize and trend sideways between $15.05 on the downside and $21.36 on the upside. This move is now starting to push shares of USU within range of triggering a near-term breakout trade. That trade will hit if USU manages to clear some near-term overhead resistance levels at $20 to $21.36 with high volume.

Traders should now look for long-biased trades in USU as long as it's trending above $15.05 and then once it sustains a move or close above those breakout levels with volume that's near or above 512,580 shares. If that breakout hits soon, then USU will set up to re-test or possibly take out it next major overhead resistance levels at $28 to $29. A more measured move to $24 or $25 might be all we get if that breakout triggers, so adjust accordingly to what the stock gives you.

To see more stocks rising on unusual volume, check out the Stocks Rising On Unusual Volume portfolio on Stockpickr.

-- Written by Roberto Pedone in Delafield, Wis.

Avis Pays More for Payless Car Rental

Seeking to expand its car rental business into the deep-value market, Avis Budget Group (NASDAQ: CAR  ) announced this morning that it's acquiring the sixth largest car rental agency, Payless Car Rental, for $50 million cash.

With Avis already sporting more the 10,000 locations in 175 countries, the 120 locations in the U.S., Canada, Europe, and South America that Payless brings with it won't bulk up operations so much, but it does give it a foot into the fast-growing deep-value end of the market and differentiates its eponymous premium offerings and mid-tier Budget brand.

Payless generated $80 million in annual revenues and Avis plans to operate the business as a separate entity from a customer perspective.

Believing the transaction will generate an attractive return on its investment, Avis Budget Group Chairman and CEO Ronald L. Nelson said, "Payless expands our global footprint, enables us to support Budget's mid-tier brand positioning, and gives us greater flexibility to capitalize on opportunities in an additional segment of the car rental market in order to help accelerate our growth."

Three companies control 95% of the car rental market: Hertz, privately held Enterprise Rent-a-Car, and Avis, which also owns Zipcar, the world's leading car sharing network, with more than 790,000 members.

Congress Restores Funding for Combat Flights

At long last, America is flying CAP again.

Air Force and Navy fighter jets returned to the skies Monday, as $1.8 billion in overseas contingency operations funding from Congress restored $423 million needed to pay for aerial operations.

F-22 Raptors training over Wake Island, Source: Air Combat Command

In a statement, Air Combat Command clarified that the funds in question had been previously been cut from its budget because of sequestration. Air Combat Commander Gen. Mike Hostage noted that as a result of these cuts, "since April we've been in a precipitous decline with regard to combat readiness."

The return of funding "reinstates critical training and test operations for the [combat air forces] fleet across the Air Force for the remainder of FY13. This impacts not just Air Combat Command units, but also CAF units assigned to United States Air Forces Europe and Pacific Air Forces." Funding has also been restored for the Air Warfare Center's Weapons School, for Aggressors (U.S. squadrons trained to play the role of "the bad guys" in training missions) and the Thunderbirds aerial demonstration team.

Air Combat Command did not say whether the funds released Monday were related to the $2.3 billion in jet fuel supply contracts awarded to ExxonMobil (NYSE: XOM  ) and other major oil suppliers, announced by the Department of Defense in June. In any event, funds authorized by Congress to reinstate these flight missions will only pay for flights through October 1. After that, and absent new funding, flight time will have to be cut again.

Use Market Fear To Generate Double-Digit Income

About a year ago, I set out to find a winning income strategy... A strategy that can generate "Instant Income" in any market environment. 

And now seems to be a good time for income investors to start considering it. 

Why? Because rising interest rates may hurt some dividend-paying stocks in the months ahead. As Bespoke Investment Group co-founder Paul Hickey put it this week: "It doesn't take much of a move in interest rates ... to make a lot of stock dividend yields quickly look considerably less attractive."  

 

And as dividend stocks become less attractive, your risk of losing money by holding the wrong ones increases.

Sure enough, as USA Today pointed out, high-yielding utilities -- an income investor favorite -- have lost around 10% since Bernanke's May 21 announcement that the Fed's bond buying program is likely to begin tapering off later this year.

Now, don't get me wrong. I'm not saying you should avoid dividend stocks altogether, but now may be the time to try an alternative approach to collecting income. That's what this strategy is for.

From July 2012 to this January, I put my "Instant Income" strategy through a rigorous test to prove my system worked in real-life trading scenarios. The results were even better than I expected. I helped readers generate thousands of dollars in income on my way to an 84% win rate, without them having to own a single share of stock.

Since then, I've launched a newsletter service to help investors navigate the world of options... and the results are even more impressive -- every single trade I've closed has been a winner. That's one winning income trade a week since Feb. 6. You can see all 16 closed trades here.

My "Instant Income" strategy allows investors to do one of two things: either earn large amounts of income... or buy high-quality stocks at a deep discount. Either way, it's usually a win-win.

The strategy involves selling puts on undervalued, high-quality stocks. It's a strategy that allows you to generate what I call "Instant Income" because when you sell a put contract, money is immediately deposited into your brokerage account... money you keep no matter how the trade turns out.

It's one of the smartest, highest-percentage winning strategies in the financial world.

To recap, "put" options give investors the right -- but not the obligation -- to sell a stock at a specified price before a specified date, known as the expiration date. Selling a put obligates us to purchase that stock from the put buyer if it falls below a specified price, known as the option's strike price. When we accept that obligation, we receive cash, or what I call "Instant Income," upfront, known as a premium.

And even during a volatile month that saw the S&P 500 fall 5.8% from its peak, every put with a June expiration date expired worthless, meaning the income we collected from selling puts is pure profit:

The chart speaks for itself. With my "Instant Income" strategy, I'm earning average returns of about 9% every 40 days. In fact, if you're an income investor, think of these returns as "yields" on the capital set aside to make these income trades. But what makes them even sweeter than traditional income investing is that I'm not holding these for an entire year to collect these returns -- I get paid upfront. 

And although the market has been volatile lately -- the CBOE Volatility Index (VIX) is up 30% in three months -- I'm not concerned. In fact, higher volatility allows me to generate even more income.

You see, option prices are determined by several factors, including the underlying stock's price, the exercise price and the amount of time until the expiration date.

But one major pricing factor that is a little more complicated is volatility.

We can get a general idea of whether volatility is high or low by looking at the VIX, also known as the "fear index." The VIX tends to rise as the market falls and traders become more anxious. On the other hand, when market prices rise, the VIX tends to decline.

That's great news for followers of my "Instant Income" strategy, because we are sellers of options, not buyers. We want them to be more expensive. That's makes it easier to find options that deliver a lot of income. And I'm taking advantage of the spike in the VIX to collect even more income while I can.

Action to Take --> Selling puts during times of high volatility is the ultimate way to be greedy when others are fearful. When most investors are panicking, options sellers can take advantage of the opportunity by selling expensive options... and generating thousands of dollars in "Instant Income."

P.S. -- Using this kind of strategy has never been easier... and once you get the hang of it, you can use it on thousands of stocks to earn a stream of income -- even if they don't pay a dividend. As I mentioned, every single one of my trades so far has been a winner, with many of them essentially paying double-digit yields. If you'd like to learn more about my "Instant Income" strategy, you can watch a presentation I put together here.