Money and Finance

Confirmation and Disconfirmation

An excerpt from the Boyles Q1 letter to investors...

Confirmation and Disconfirmation

“The exceptions to any rule are most interesting in themselves, for they show us that the old rule is wrong. And it is most exciting, then, to find out what the right rule, if any, is. The exception is studied, along with other conditions that produce similar effects. The scientist tries to find more exceptions and to determine the characteristics of the exceptions, a process that is continually exciting as it develops. He does not try to avoid showing that the rules are wrong; there is progress and excitement in the exact opposite. He tries to prove himself wrong as quickly as possible.” -Richard Feynman (The Meaning of It All)

There is a powerful force in human psychology known as confirmation bias. This drives people to look for evidence that confirms what one already believes—or wants to believe—and to ignore, or rationalize, evidence that contradicts those beliefs. It is an especially prevalent cause of investment error. As investors, we want to find great ideas. We want to find great management teams. And we want to uncover a story that we think the market has gotten wrong, so that we may profit.

And to do this, we spend a lot of time learning. To some extent, our job as fundamental value investors is part language learning, and part investigative journalism. The language learning occurs as we look at unfamiliar businesses or industries. Unless it is a company in the exact same line of business as one we’ve already studied, there are likely to be a few new terms and products to learn about. Sometimes the amount of language learning is extremely small, and sometimes it is large, but it is usually fairly straightforward, and less prone to error.

The larger part of the research process is that akin to investigative journalism. It is the deep dive into the business, its people, and the competitive landscape. It is large not just because it requires a lot of effort, but because it also requires interpretation. The more subjective the interpretation, the greater the chance for error; and there are few, if any, greater causes of investment error than human psychology.

Because investors want to invest, a positive story forms in their minds as they think about and research potential investments. Almost any piece of data that can be viewed in a positive light is so viewed, and that which can’t is normally explained away, often by assuming that the negatives are far outweighed by the positives. Historical achievements are seen as inevitability, or as managerial brilliance destined to continue. But the narrative of history isn’t always what it seems. As Yuval Noah Harari writes in his book Sapiens: A Brief History of Humankind:

“...the better you know a particular historical period, the harder it becomes to explain why things happened one way and not another…It is an iron rule of history that what looks inevitable in hindsight was far from obvious at the time.”

This holds true with business history just as it does with human history. The more you learn about the biographies of certain businesses, such as Wal-Mart or Google, the more you begin to realize that not only were outsiders incapable of knowing what would happen, but those directly involved in the businesses were just about as incapable as everyone else. More pressure from larger competitors or a potential acquirer willing to pay just a little more would probably have had major impacts on the outcomes of those businesses, as well as many others.

How do we use this knowledge to help us invest? How do we try to prevent our minds from using information from the past and present to cloud our picture of the future? We attempt to give special attention to evidence that disconfirms our current viewpoint. There is a natural tendency to close one’s mind to such evidence and dismiss it as incorrect or unimportant. But learning to welcome and actively search for disconfirming evidence, as well as actively questioning the implications if such evidence is true can give one a big advantage in investing and in life. It can greatly improve one’s mental processing over time, as it did for Charles Darwin, as described by Charlie Munger in Poor Charlie’s Almanack:

“He trained himself, early, to intensively consider any evidence tending to disconfirm any hypothesis of his, more so if he thought his hypothesis was a particularly good one.…Darwin’s practice came from his acute recognition of man’s natural cognitive faults.…He provides a great example of psychological insight correctly used to advance some of the finest mental work ever done.”

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