Last quarter we introduced our Behavioral Finance series. Again, in my opinion, the key finding is not that we investors are irrational, but rather that we tend to be irrational in predictable ways (i.e., when large numbers of investors face similar decisions amid uncertainty, we tend to behave in a similar way). These tendencies, if understood, can help us make better decisions. Last quarter we discussed overconfidence. This quarter we will cover confirmation bias.
Confirmation bias occurs when people seek out or evaluate information in a way that fits with their existing thinking and preconceptions. When you have a strongly held belief, it’s easy to see validation everywhere. This habit of noticing information that affirms your beliefs and opinions while also ignoring or denying contradictory information is known as confirmation bias. It’s powerful in part because it’s reassuring. Once you’re comfortable with an idea, you feel better when you hear information that confirms you’re right. A great example of this is how we choose our news sources (i.e., if you are conservative, you are much more likely to watch Fox News than CNN).
This can be especially harmful when it comes to making financial decisions. That’s because investors with a strong confirmation bias truly believe that they’re making an informed decision—and they don’t realize the information they’re basing their choices on has been skewed by their own preconceptions. For example, a client who’s particularly convinced that a certain investment is a good buy will pay attention to the facts that support such a belief (such as strong recent revenue growth) while glossing over other information (such as margin compression).
Every investment opportunity requires opposing views; someone must be willing to sell and someone must be willing to buy. So by definition, there is supporting and opposing information on every transaction. A quality decision-making process requires a strong conviction based on supporting evidence, but also requires a thorough evaluation of information that conflicts with your thesis.