Lessons from David Dreman (Part 3)

I want to wrap up this mini-series today on David Dreman by discussing a few more cognitive biases, or heuristics, and offering some commentary on effectiveness.

David Dreman may be a living example of a repetitive theme throughout this blog: ideas that sound good but truly have no merit. I make no performance claims about Dreman Value Management. I mentioned backtesting his idea of investing in out-of-favor issues because I have not done so myself. Contrarian investing is conventional wisdom discussed in books and seminars for traders, which is a big reason it resonates with me and feels right.

I will close with discussion of a few other types of cognitive heuristics.

Historical consistency leads to greater confidence about predictability. Dreman found investors have more confidence in a stock that consistently rises with 10% earnings growth than a more volatile stock with 15% earnings growth. Is a less volatile stock more likely to outperform into the future? That is an empirical question.

The anchoring heuristic describes a common human tendency to rely heavily on the first piece of information when making decisions. Other judgments are made in reference to the anchor, and bias exists toward interpreting other information around the anchor. For example, a stock purchase price defines what is “good” (higher subsequent prices) and “bad” (lower prices). These are purely subjective judgments. Mr. Market certainly does not care about my cost basis.

Finally, confirmation bias is the tendency to search for, remember, interpret, and favor information in a way to confirm preexisting beliefs or hypotheses while giving less consideration to alternative possibilities. The effect is stronger for deeply entrenched beliefs and emotionally charged issues, which would certainly include the prospect of making money!

Confirmation bias is the main reason I seek collaboration for trading system development, which I have written for a long time. I do not want to be blinded by confirmation bias if I get a whiff of something good. In this case, other critical minds can better maintain objectivity; the idea remains less emotionally-charged because it is not theirs.

Certainly I would rather be proven wrong in the development stage rather than with real money on the line. Confirmation bias circumvents this and collaboration is the antidote.