Biases and preconceived notions generally harm our own critical decision-making. It is often easier, especially when it comes to complex issues, to buy into someone else's opinion rather than formulate your own beliefs and convictions. In some fields, it is necessary to trust the professionals, such as physicians or engineers. But in the shifting world of the financial markets, formulating your own convictions is especially important. Often, out of convenience, we buy stocks based on the tips of others who have more 'experience,' without taking the time to question their recommendations. Even if we don't directly act on a stock recommendation, hearing somebody casually express a bullish or bearish sentiment toward a particular equity or sector immediately prejudices us. Thus, consciously or not, even when we do our own research, we may start with a preconceived notion.
There are countless indicators that tip off investors and speculators as to how the market views a stock. A common way to test market sentiment is by looking at a stock chart. It's a pretty safe assumption that if a stock is rising higher and higher, setting new 52-week highs, then investors favor the company. The reverse also applies; if a stock is getting taken to the cleaners, the market thinks poorly of it. A less obvious way to gauge market sentiment is by seeing what "sell-side" analysts - Wall Street analysts who work for retail brokerage firms - have to say about a particular stock. While you generally have to pay for the actual research reports, there is no fee to check many investment websites which list how many analysts cover a particular stock and what their opinion is on it. You can also see what hedge funds and other institutional funds are popular by using the Securities and Exchange Commission website to pull up 13F statements of various funds. The 13F reveals all the stocks a particular fund owns. Also, on investing sites such as Yahoo Finance, you can see the short interest of a company. Short interest tells you what percent of shares are sold short, indicating that investors believe the company is going to lose value.
With this plethora of information, we construct a mosaic of market sentiment and it is inevitable that we are thereby influenced to some extent. However, there are ways to evaluate outside influences to mitigate unintentional bias. First of all, it is critical to do your own research about the company, not the stock. Look at the 10-K, read the conference call transcripts and financial statements, even pick up the phone and call the company. You would be surprised how many people are willing to discuss how their business is doing, without of course divulging inside information. Once you understand how the company works and makes money, you will form your own opinion of a business' prospects and thereby be able to consider buying or shorting that company's stock.
Also, playing devil's advocate is a great way to raise questions and beat the biases - especially confirmation bias, when you only accept the information that verifies your beliefs. Legendary hedge fund manager Julian Robertson regularly questioned his investment theses. If he didn't have total conviction about an idea after honestly grilling himself, he wouldn't invest in it. Other investors suggest finding the smartest people you know and have them question your assumptions. If you're looking at a company to invest in, think of all the risks and really question if you should own that equity, regardless of the consensus.
Finally, you can control, to some extent, what information you are exposed to. After all, nobody is forcing you to read the "sell-side's" recommendations. Many investment businesses, such as mutual funds, pension funds and hedge funds, don't allow their research analysts, who make proprietary recommendations, to look at "sell-side" research, lest it influence their thinking.
We all use outside resources to learn more, whether it's from a history book to do research for a paper or Google Finance for a stock. But coming into the process with an open mind about a company allows us to use these resources prudently, to help fill gaps in our knowledge, and not merely to act in support of a preconceived investment thesis.
Harrison's column runs biweekly Tuesdays. He can be reached at h.freund@cavalierdaily.com.
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