What Is Confirmation Bias?
Confirmation bias is a term from the field of cognitive psychology that describes how people naturally favor information that confirms 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 confirms their existing opinions and ignore facts or data that refutes them, they may skew the value of their decisions based on their own cognitive biases. This psychological phenomenon occurs when investors filter out potentially useful facts and opinions that don’t coincide with their preconceived notions.
- Confirmation bias is the tendency of human beings to actively search for, interpret, and retain information that matches their preconceived notions and beliefs.
- The confirmation bias concept comes from the field of cognitive psychology and has been adapted to behavioral finance.
- Confirmation bias flourishes because it's an efficient way to process information, it promotes self-esteem, and it eases stress by eliminating conflict and contradictions.
- Investors should be aware of their own tendency towards confirmation bias so that they can overcome poor decision-making, missing chances, and avoid falling prey to bubbles.
- Seeking out contrarian views and avoiding affirmative questions are two ways to counteract confirmation bias.
Understanding Confirmation Bias
Confirmation bias affects perceptions and decision-making in all aspects of life, but it can create particular problems for investors. When researching an investment, they might inadvertently look for or favor information that supports their preconceived notions about the asset or strategy and fail to register or to under-weigh any or data that presents different or contradictory ideas. The result is a one-sided view and a self-reinforcing loop. Confirmation bias can thus 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 do not always 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 is happening in the market.
Types of Confirmation Bias
Confirmation bias can be broken down into several sub-categories. Here are some of the most common.
This sort of confirmation bias relates to making a decision or adopting a view and then seeking information that supports it. This can happen unconsciously: Even in the way a person searches for evidence or phrases a question can reflect the preference, and so yield the proof they want.
This variety of confirmation bias relates to how people process and evaluate data. Typically, evidence that conflicts with preconceptions causes discomfort and so is ignored or given little consideration—while confirming evidence is accepted uncritically or at least more readily. This disparity in interpreting info explains why research so often fails to change people's opinions on issues.
This type of confirmation bias relates to memory. Past experiences and events influence current thinking and behavior, of course. But 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 also suggest that information confirming our biases is more likely to remain in our memories, and information contradicting 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 facts that contradict or refute that belief. Actively resisting news that goes against what we already think or believe, in effect.
Why Does Confirmation Bias Exist?
What causes confirmation bias, and why do humans have it? Although it can cause problems, it seems to make life easier too. Below are a few reasons why.
It's an information jungle out there, and it keeps getting thicker all the time in our digital/social media era. We don't have the time or the energy to evaluate everything equally to form unbiased decisions. By encouraging us to look for or accept certain types of info, confirmation bias frankly helps cut through the clutter. It's an efficient, if limited, way to edit evidence and process data.
It Helps Self-Esteem
People like to feel good about themselves—that they're intelligent, decent, and right. Discovering that they're incorrect makes people feel bad 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 anxious individuals with low self-esteem.
It Alleviates Stress
"The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function,” F. Scott Fitzgerald wrote in “The Crack-Up,” a 1936 essay. Ah, but for most people, maintaining a pair of contradictory 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 facts—what we want 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.
Confirmation bias encourages investors to remain preoccupied with their own prejudices and stay in their comfort zones. As a result, they might easily miss out on new (to them) strategies, products, and investment opportunities. They might cling to notions like "never dig into principal" or "never go into debt," even when their individual circumstances dictate that doing the opposite makes more financial sense.
Diversification is a technique that allocates investments across various financial instruments, industries, and asset classes that would each react differently to the same event. Although it mainly aims to reduce risk, it can maximize returns (by avoiding losses) as well. 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, thus exposing themselves to greater risk.
Being Victimized by Bubbles
Bubbles occur 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 doing it," people with confirmation bias are prone to invest more in asset bubbles, swayed by the consensus view—and ignoring any contrarian voices warning that the uptick is getting out of hand, that the elevated prices aren't justifiable or sustainable. So they're likely to incur a lot 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 mimic the financial actions of the majority, following the crowd, so to speak. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-offs.
Example of Confirmation Bias
Suppose an investor hears a rumor 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 only 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 loss—just before it turns around and climbs to an all-time high.
Overcoming Confirmation Bias
Seek contrary advice: The first 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 should seek alternative ideas that challenge their point of view. It is good practice to make a list of the investment’s pros and cons and reassess it with an open mind.
Avoid affirmative questions: Investors should not ask questions that confirm their conclusions about an investment. For example, an investor who wants to buy a stock because it has a low price-earnings (P/E) ratio would be affirming their findings if they only asked their financial advisor about the company’s valuation. A better approach would be to ask the broker for more information about the stock, which can be pieced together to form an unbiased conclusion.