Tuesday, April 19, 2005

Profiting from confirmation bias

Investors and business executives can profit from confirmation bias -- the notion that people eagerly gobble up information that confirms their pre-conceived ideas and reject the rest. Here are three examples:
  • Microsoft/IBM. Bill Gates tapped confirmation bias to make the most valuable business decision in history. In the early 1980s, IBM was looking for an operating system for its PC. Gates paid $75,000 to license one from Seattle Computing. Gates sold IBM the rights to the OS for use on IBM PCs for a pittance. IBM, assuming that no PC-clone market would emerge, granted Gates the license for the OS on the clones. IBM had convinced itself that Gates was naïve about the emergence of PC clones. If Gates was right, IBM reasoned, then IBM was no longer the marketing powerhouse it believed itself to be. When the PC clone market grew, Gates profited from IBM’s confirmation bias.
  • Williams Communications Group. Confirmation bias creates opportunities in stocks as well. In March 2001, Williams Companies spun off its holdings in fiber network operator, Williams Communications Group (WCG). After reviewing its finances and its prospects, I was quoted in the media that WCG, which traded for $9 a share, was likely to go bankrupt. In mid-September 2001, WCG filed a quarterly statement which brought the bankruptcy closer to reality – I was again quoted in the media predicting a WCG bankruptcy. That day I received a warm-hearted e-mail from a WCG investor suggesting that I take my family in an airplane and share the fate of the 9/11 victims. Since the investor had indicated that he was an engineer, I thought he might be interested in the facts. After sending him the data on which I based my conclusion, the investor replied that he agreed with my analysis and that he had never bothered to read the 10q. I am convinced that like many investors, he only wanted to read information that confirmed his decision to buy the stock.
  • Electronics Test Equipment Company. In the fall of 2000 I worked closely with a company whose confirmation bias kept it from seeing that it stood at the precipice of a huge revenue drop. This company, which sold testers to companies that made network switching gear for companies like WCG, was having its best year ever. After analyzing the finances and prospects of its customers’ customers, I suggested that trouble was ahead. The verdict on my speech at a corporate management meeting was dismissive: “This consultant doesn’t understand our business.” A year later the client’s revenues had declined by two-thirds and when its managers sought a reason for the decline, they realized that events had unfolded along the lines I had predicted.

The point of these stories is that confirmation bias is an opportunity for an objective analyst. If IBM had been more objective, it might have recognized that Gates was not as naïve as he appeared. If WCG investors had read objectively the information that was publicly available, they might have bailed out before WCG filed for bankruptcy. And if the test equipment company had listened with a more open mind, it could have cut costs and diversified its customer base in anticipation of the decline in its revenues.

Unfortunately, once an investor or manager has committed capital, it is very difficult to avoid the confirmation bias. Thus opportunities abound to profit from it.


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