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 identify that this fundamental principle applies to investors in notable ways. Because investors seek out information that confirms their existing opinions and ignore contrary information that refutes them, they may skew the value of their investing 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.

Key Takeaways

  • Confirmation bias is a cognitive process which is natural to everyone.
  • The concept comes from the field of cognitive psychology but has been adapted to behavioral finance.
  • Investors should be aware of their own tendency towards confirmation bias so that they can overcome poor decision making.

Understanding Confirmation Bias

Confirmation bias can create problems for investors. When researching an investment, someone might inadvertently look for information that supports his or her beliefs about the investment and fail to see the information that presents different ideas. The result is a one-sided view of the situation. Confirmation bias can thus cause investors to make poor decisions, whether it’s in their choice of investments or their buy-and-sell timing.

Confirmation bias affects perceptions and decision making in all aspects of life and can cause investors to make less-than-optimal choices. Seeking out people and publications with alternative opinions can help overcome confirmation bias and assist in making better-informed decisions.

This phenomenon 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. Confirmation bias helps explain why investors do not always behave rationally and perhaps supports arguments that the market behaves inefficiently.

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 stories that confirm the likely bankruptcy scenario and miss a story about a new product the company has just launched that is expected to perform well and 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 Confirming 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 confirming 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.