How Confirmation Bias Could be Hurting your Investment Performance
Have you made up your mind on just about everything, even before you know what it is? For instance, when you meet someone, is your opinion of the person formed from the first impression? Or, when you hear a political argument from the other side, is your mind opened or closed? Are you able to concede the “good points” the other side make, or do you dismiss the whole argument? We encounter people and ideas every day, and, while most of us would like to think we are open-minded, human nature, being what it is, makes it extremely difficult to discard our preconceived opinions. So, we almost instinctively filter out the information that doesn’t support our preconceived notion or opinion, at least initially. Behavioral psychologists refer to this kind of selective thought process as “confirmation bias.”
What does this have to do with investing? Well, when you consider that our investment choices are usually guided by a thought process, it can mean everything. If that thought process is clouded by confirmation bias, you may be making important, sometimes life-changing, investment decisions with one-sided information, and that can dramatically skew the big picture you need to make fully informed decision. Some of the more costly mistakes investors make can be attributed to confirmation bias which often leads to poor decisions based on incomplete information.
Take, for example, the investor who hears his colleagues bragging about the latest hot stock they all bought which has already doubled in price. No one wants to be left out of the next big thing, but at least this investor has the sense to do some research on his own. As he pours through the reports and surfs the internet for validation of their claims, half of his mind is racing with thoughts of the new car he will buy, as well as the possibility that he will be thought of as a “chump” for not getting in on the deal. Granted, he is allowing greed and fear to creep into the process; however, in doing so, in begins to filter out any information that might raise red flags and, instead, focus on the information that validates the investment. Now, imagine that this investor made that investment at the height of the Dot Com Bubble.
Confirmation bias works subtly, some would say insidiously, inside the minds of investors as they seek nothing more than to make the best possible decisions with their money. Even those who spend as much time analyzing the cons as they do the pros of a given investment, confirmation bias tricks the mind into giving more weight or credence to the pros, if there is already a preconception in favor of it. Or, more overtly, it simply allows us to dismiss or discount information that doesn’t conform to our beliefs. That’s a very dangerous mindset when your money is at stake.
Overcoming Confirmation Bias
Overcoming confirmation bias is not as easy as you might think. It’s one thing to be aware of it and even make a point of dealing with it. However, it’s that same bias that often presents us from taking the necessary steps to avoid it. If you are the president of the United States, let’s say, and your policies seem to always go in the wrong direction as far as the public is concerned. You may convince yourself that you are right and the public is wrong if all you do is surround yourself with people who agree with you. Having the strength and security to include people who have differing viewpoints in your life can cure you of confirmation bias; if you are willing to examine their viewpoints with an open mind.
Overcoming confirmation bias doesn’t mean abandoning your beliefs or even your preconceived opinions; rather it means recognizing how your bias could lead to making bad decisions in any aspect of life.
Being aware of it and recognizing that it could, in fact, cloud your judgment is the first step. Then, in gathering and analyzing information, focus on that which doesn’t conform to your opinion or belief and try to understand why. This might involve inviting those who don’t share your opinion to give you their view without you arguing yours. Just listen and evaluate. The same can be done by reading blogs and articles by people with different views. The most important thing is to work through the thought process more rationally without fighting opposing viewpoints.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2014-2015 Advisor Websites.