Confirmation Bias

What Is Confirmation Bias?

Confirmation bias is a term from the field of cognitive psychology that describes how people naturally favor information that affirms their previously existing beliefs.

Experts in the field of behavioral finance find that this fundamental principle applies to investors in notable ways. Because investors seek out information that affirms their existing opinions and ignore realities or data that refutes them, they might skew the value of their decisions based on their own cognitive biases. This psychological phenomenon happens when investors filter out potentially useful realities and opinions that don't coincide with their preconceived thoughts.

Understanding Confirmation Bias

Confirmation bias affects perceptions and decision-production in all aspects of life, yet it can create particular problems for investors. When researching an investment, they could inadvertently search for or favor information that supports their preconceived thoughts about the asset or strategy and fail to register or to under-weigh any or data that presents different or inconsistent ideas. The result is a one-sided view and a self-reinforcing loop. Confirmation bias can along these lines cause investors to make poor decisions, whether it's in their choice of investments or their timing of trades.

Confirmation bias helps explain why investors don't necessarily in all cases behave rationally and perhaps supports arguments that the market behaves inefficiently. The syndrome is a source of investor overconfidence and helps explain why the bulls tend to remain bullish and the bears tend to remain bearish regardless of what's going on in the market.

Types of Confirmation Bias

Confirmation bias can be broken down into several sub-categories. Here are some of the most common.

Biased Research

This kind of confirmation bias relates to pursuing a choice or adopting a view and afterward seeking information that supports it. This can happen unknowingly: Even in the manner in which a person searches for evidence or phrases a question can reflect the preference, thus yield the proof they need.

Biased Interpretation

This variety of confirmation bias relates to how people process and evaluate data. Typically, evidence that conflicts with preconceptions causes discomfort as is ignored or given little consideration — while affirming evidence is accepted uncritically or possibly more readily. This disparity in interpreting data explains why research so often fails to change people's opinions on issues.

Biased Recall

This type of confirmation bias relates to memory. Past experiences and events influence current thinking and behavior, of course. However, people remember things in selective ways, and often that selectivity serves to back up current beliefs — as opposed to the current beliefs being shaped by the memories. In other words, we recall the past in a way that reinforces the present. Some theories additionally suggest that information affirming our biases is more likely to remain in our memories, and information going against them is more likely to be forgotten or repressed.

A related syndrome to confirmation bias is belief perseverance or persistence: the inability of people to change their own belief even upon receiving new information or realities that go against or refute that belief. Actively resisting news that goes against what we already think or believe, in effect.

For what reason Does Confirmation Bias Exist?

What causes confirmation bias, and for what reason do humans have it? In spite of the fact that it can cause problems, it seems to make life easier too. Below are a few reasons why.

It's Efficient

It's an information jungle out there, and it keeps getting thicker all the time in our advanced/virtual entertainment era. We don't have the time or the energy to evaluate everything equally to form unbiased decisions. By encouraging us to search for or accept certain types of data, confirmation bias honestly helps cut through the clutter. It's an efficient, whenever limited, method for editting evidence and process data.

It Helps Self-Esteem

People like to feel great about themselves — that they're intelligent, decent, and right. Discovering that they're incorrect makes people feel awful about themselves. Therefore, people will seek information that supports their existing opinions, decisions, and desires. In other words, confirmation bias is a confidence booster. It's no surprise that, while anyone can be prone to it, confirmation bias often can be found in restless individuals with low self-esteem.

It Alleviates Stress

"The test of a top notch intelligence is the ability to hold two opposed ideas in the psyche at the same time, yet retain the ability to function," F. Scott Fitzgerald wrote in "The Crack-Up," a 1936 essay. Ok, however for a great many people, keeping a pair of disconnected beliefs causes cognitive dissonance — a state of mental distress and unease that often impedes functioning. To minimize this dissonance, confirmation bias kicks in. By reinforcing one set of realities — what we need to see, hear, or believe — it alleviates the paralyzing conflict.

Impact of Confirmation Bias on Investments

Confirmation bias can be particularly dangerous for investors. Reflecting the direct influence of desire on beliefs as it does, it causes irrational behavior — and investing is one area where emotion emphatically has no place.

While countless ways exist for confirmation bias to (adversely) affect investment decisions, here are three common effects.

Missing Chances

Confirmation bias encourages investors to remain preoccupied with their own prejudices and remain in their comfort zones. As a result, they could easily pass up new (to them) strategies, products, and investment opportunities. They could grip to thoughts like "never dive into principal" or "never stray into the red," even when their individual circumstances dictate that doing the opposite makes more financial sense.

Disregarding Diversification

Diversification is a technique that allocates investments across different financial instruments, industries, and asset classes that would each react differently to the same event. In spite of the fact that it chiefly plans to reduce risk, it can maximize returns (by keeping away from losses) too. Confirmation bias can encourage investors to become obsessed with a few companies or a few investment types. This causes them to ignore diversification and concentrate their holdings in a single stock or asset class, hence exposing themselves to greater risk.

Being Victimized by Bubbles

Bubbles happen when prices for a particular asset or investment rise far above its real value in increasingly speculative trading. Since bubbles are all about investors buying "because everyone's making it happen," people with confirmation bias are prone to invest more in asset bubbles, swayed by the consensus view — and overlooking any contrarian voices warning that the uptick is getting wild, that the elevated prices aren't justifiable or sustainable. So they're likely to cause a ton of financial damage when the bubble pops, as it inevitably does.

The speculative activity that inflates investment bubbles is part of another important concept in behavioral finance, called herd behavior or mentality. It states that people tend to copy the financial activities of the majority, following the crowd, in a manner of speaking. Herding is famous in the stock market as the cause behind sensational rallies and sell-offs.

Example of Confirmation Bias

Suppose an investor hears gossip that a company is on the verge of declaring bankruptcy. Based on this information, the investor considers selling the stock. When they go online to read the latest news about the company, they read just the articles that repeat the likely bankruptcy scenario and miss a story about a promising new product the company has just launched that is expected to increase sales. Instead of holding the stock, the investor sells it at a substantial misfortune — just before it pivots and moves to an all-time high.

Overcoming Confirmation Bias

Seek opposite advice: The initial step to overcoming confirmation bias is to have an awareness that it exists. Once an investor has gathered information that supports their opinions and beliefs about a particular investment, they ought to seek alternative ideas that challenge their point of view. It is great practice to make a rundown of the investment's pros and cons and reassess it with an open psyche.
Stay away from affirmative questions: Investors shouldn't ask questions that affirm their decisions about an investment. For example, an investor who needs to buy a stock because it has a low price-earnings (P/E) ratio would be certifying their discoveries if they only asked their financial advisor about the company's valuation. A better approach is ask the broker for more information about the stock, which can be pieced together to form an unbiased end.

Highlights

• Confirmation bias is the tendency of human beings to actively search for, interpret, and retain information that matches their preconceived thoughts and beliefs.
• The confirmation bias concept comes from the field of cognitive psychology and has been adapted to behavioral finance.
• Seeking out contrarian views and staying away from affirmative questions are two methods for counteracting confirmation bias.
• Confirmation bias flourishes because it's an efficient method for processing information, it promotes self-esteem, and it eases stress by eliminating conflict and inconsistencies.
• Investors ought to be aware of their own tendency towards confirmation bias so they can overcome poor decision-production, missing chances, and try not to fall prey to bubbles.