Seeing what we want

Many of you, I suspect, regard the eurozone's crisis as a vindication of your prior view that monetary union was destined to fail. If so, you might be prone to the confirmation bias, a bias that has implications for both stock-picking and the crisis.

The confirmation bias is our tendency to interpret new evidence in such a way as to corroborate our existing opinion, and to rationalise away or to underweight disconfirming evidence. Like all cognitive biases, this isn't always an error - sometimes we really were right all along - but it can lead us into error, by magnifying our past mistakes.

And, say Sebastien Pouget and Stephane Villeneuve of the University of Toulouse, this can help explain why there is momentum in share prices. After we have bought a stock the confirmation bias causes us to see new evidence as supportive of our decision to buy, while any bad news is rationalised away as a blip. We are thus tempted to buy more. If enough traders focus on the same stocks, there will then be momentum in prices, as the price rise caused by the initial buying is following by more buying.

Rational investors won't always correct this error. This could be because there are limits on how far they can short sell a stock. Or it could be because they recognise behavioural risk - the danger that irrational markets can get even more irrational. It's well-known by now that the 'smart money' doesn't necessarily drive the stupid money out of the market.

This has a useful implication. It implies that momentum investing will be especially successful (on average, of course) for shares whose price rise is accompanied by high trading volume. This is because high volume is a sign that traders disagree - it takes a difference of opinion to make a market - and disagreement might be a sign that irrational buying is present.

But the confirmation bias and momentum work both ways. They can drive prices down a long way as well as up.

Which brings us back to the euro crisis. It could be that one force behind the sell-off in shares and in southern European bonds is the confirmation bias; traders regard the current mess as confirmation of their belief that monetary union and/or European politicians are dysfunctional. This implies that otherwise reasonable efforts to reduce the euro's problems will be dismissed as insufficient - they might merely confirm traders' suspicions that ministers are 'kicking the can down the road'; there's are reason why this has become a cliché.

And this in turn implies that measures to fix the euro now will have to be bigger and more radical than they would have had to be a few months ago - because only dramatic action will be enough to shatter those prior perceptions of dysfunctionality.

Despite the weekend's deal on a Spanish banking rescue, though, there is little sign that this will happen.

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