Confirmation Bias: Helping to Break the Spell
As human beings, it’s instinctual to take in information about the world around us and use it to inform our decisions and beliefs. And while this instinct has helped us evolve, it is important to be aware that we are susceptible to a psychological tendency known as confirmation bias, the tendency to interpret new experiences in a way that conforms to our existing beliefs. In this piece, we discuss how confirmation bias applies to investing and how financial planners can help individuals overcome this mental trap to achieve their financial goals.
What is confirmation bias?
Confirmation bias is a theory in psychology which states that we unconsciously pay attention to and search for information in a way that conforms to our preexisting beliefs or preferences. Furthermore, the presence of confirmation bias has been shown – through research – to limit our ability to make rational decisions. Confirmation bias is tricky to detect in ourselves and can lead to the discounting of new information when it conflicts with our preexisting beliefs.
Confirmation Bias Isn’t Bad – It’s Evolution
Confirmation bias is generally helpful and evolutionarily efficient. Reinforcing what we already know aids in making good decisions quickly. For example, if you hear the sound of a lion roaring, you wouldn’t want to wait around to “see” the actual lion to confirm your suspicions were correct. You’d instantly check the sound against your memory, judge that indeed a lion is lurking in the brush, and you’d run away. As a survival instinct, confirmation bias makes complete sense. The problem with applying these same cognitive skills in the modern world is that it can lead to the misinterpretation of important data and drive us to collect evidence supporting our beliefs while at the same time minimizing contradictory information. Why is this a problem?
Confirmation Bias in Action
Legendary investor, Warren Buffett, captured the essence of confirmation bias when he said, “What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.” When we apply this bias to personal investing, the results can be detrimental to one’s financial health.
Here are two examples of how confirmation bias can lead to poor investment outcomes.
Picture an investor who has a favorable opinion of a company and chooses to invest in the company as a result of this opinion. Once invested, the individual may continue to selectively collect information supporting their belief that it is a worthwhile investment, and may even ignore adverse reports about it. Furthermore, an investor’s bias may lead them to believe that a decline in the stock price is temporary, and continue to seek information supporting the belief the stock will soon recover. Or, the investor may think everyone else is misinterpreting key pieces of data and that they alone see it’s just a matter of time before the market recognizes the value of the company.
The problem with this method of thinking is that, in reality, the company may never recover. In this case, the investor’s confirmation bias clouds their ability to see the negative aspects of the company, leading them to discount the price signal the market is sending. Eventually, this investor will either hold the stock forever at a reduced price or be forced to sell at a loss. Either way, this is a poor investment outcome.
“Outsmarting” the Market
Another example relates to real estate investing. A real estate investor who enjoys the benefits of a housing boom is likely to attribute his or her success to personal skill. In contrast, investors who see the value of their real estate holdings plummet tend to blame the market, other investors, or just plain bad luck. In this case, the successful real estate investor believes skill alone led to their success, and heavily favors real estate over other opportunities. Meanwhile, the less successful investor may discount the value of real estate, and seek other investments at the expense of a prudent allocation to the real estate market. Both of these individuals will find information validating their preconceived opinions and ignore information contrary to their firmly held beliefs.
Helping to Break the Spell
Financial planners aren’t immune from confirmation bias. We are, after all, human beings. However, we tend to be aware of our own biases, and often find ways to challenge our thinking. Some of the greatest value a financial planner provides is this deep understanding of how biases affect investment decisions. An excellent financial planner will tactfully educate Clients, so harmful biases are revealed and mitigated.
Many financial planners, as we do here at Yeske Buie, utilize a systematic and rigorous investment process which aids in making sound investment choices. Many financial planners are also well versed in the best available academic research supporting quality investment decisions. A systematic and grounded investment process allows investors to remain disciplined despite the tendency to view the world through the lens of firmly held beliefs. This application of knowledge, which sometimes runs counter to personal biases, helps Clients stay invested even in turbulent times.
In addition to helping Clients make sound investment decisions, skilled financial planners function as what we like to call a “thinking partner.” A thinking partner helps Clients “walk their ideas around the block.” In this way, financial planners apply expertise and experience to act as an external partner with the Client, helping Clients view problems in a more reasoned, less emotional way.
Seeing Things Through A New Lens
Confirmation biases aren’t bad. They’re inherent in our thinking and are vital as we navigate the world around us. However, when it comes to financial matters, confirmation biases can be harmful because they can cause us to overlook essential pieces of information that shed light on a complex problem. It is through the introduction of competing views that we learn to see the world through a new lens. So next time you have a challenging financial situation or if you want to have an objective look on a financial problem, give us a call. We’d love the opportunity to be your thinking partner.