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  1. Behavioral Finance: Introduction
  2. Behavioral Finance: Background
  3. Behavioral Finance: Anomalies
  4. Behavioral Finance: Key Concepts - Anchoring
  5. Behavioral Finance: Key Concepts - Mental Accounting
  6. Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
  7. Behavioral Finance: Key Concepts - Gambler's Fallacy
  8. Behavioral Finance: Key Concepts - Herd Behavior
  9. Behavioral Finance: Key Concepts - Overconfidence
  10. Behavioral Finance: Key Concepts - Overreaction and Availability Bias
  11. Behavioral Finance: Key Concepts - Prospect Theory
  12. Behavioral Finance: Conclusion

By Nathan Reiff

There’s an old adage that states that “seeing is believing.” This may be the case, but there are also some situations where this concept can be problematic. If what you perceive does not accurately represent reality, for instance, we may see another example of a bias which has an impact on an individual’s behavior within an economy. In this chapter we’ll explore how confirmation and hindsight biases impact our perceptions and our subsequent decisions.

Confirmation Bias

Most of the time, whether we realize it or not, we go into many types of interactions with a preconceived opinion of some type. During a first encounter, it can be difficult to shake these opinions, as people tend to selectively filter and pay more attention to information which is in support of their opinions as they simultaneously either ignore or rationalize the rest of the information. This selective thinking impacts people in many different ways, and it is known as a confirmation bias.

Confirmation biases in investing suggest that an investor is more likely to look for information that is in support of his or her idea about an investment than he or she is to find data which contradicts it. Because we take in these types of information differently, we’re often subject to faulty decision making as a result of one-sided information which skews our frame of reference. Investors tend to have an incomplete picture of an investment situation because of confirmation bias.

As an example, consider an investor who hears about a particularly hot stock from an unverified source. That investor may conduct research on the stock in order to “prove” that its supposed potential is real. In this case, the investor finds plenty of positive information which helps to confirm his bias (this might include growing cash flow or a low debt/equity ratio). At the same time, he is likely to gloss over or ignore major red flags, such as a loss of critical customers or dwindling markets for the company.

Hindsight Bias

Hindsight bias is another common perception bias. This tends to take place in situations where a person believes (after the fact) that the onset of a previous event was both predictable and obvious. In many cases, however, the event was by no means obvious or predictable.

In hindsight, many events seem very obvious. From a psychological standpoint, we may experience hindsight bias as a result of a human need to find order in the world; we create explanations which allow us to believe that events from the past were predictable. Hindsight bias and the ways of thinking wrapped up in it are not necessarily bad, but they can sometimes lead investors to find erroneous “links” between the cause and the effect of an event, thereby oversimplifying the situation and making poor decisions in the future.

Take an example of individuals who believe that the technology bubble of the early 2000s was obvious. The same kinds of hindsight bias can be found for essentially any historical bubble, including the tulip bubble from the 1630s. In each case, this represents a clear example of a hindsight bias: if the information about a bubble had truly been obvious, it’s likely that investors would not have bought in, and the bubble would not have burst. (To learn more, read The Greatest Market Crashes.)

Hindsight bias can lead investors down the dangerous path toward overconfidence. If an investor grows overconfident, he or she maintains an unfounded belief that he or she possesses superior stock-picking or investing abilities. Inevitably, this ends up leading to damaging financial decisions if allowed to unfold over a long period of time.

Avoiding Confirmation and Hindsight Bias

Confirmation and hindsight biases are tendencies that we have to focus on information that confirms some pre-existing thought, or to generate an explanation for a past event which makes it seem inevitable or obvious. There are numerous problems with these biases, but one of the most important to keep in mind is that the fact of being aware that we maintain confirmation and hindsight biases is not sufficient to prevent us from having them. For that reason, investors are encouraged to find someone to act as a “dissenting voice of reason.” If forced to defend your investment decisions and viewpoints from a contrary opinion, you’re more likely to see holes in your arguments.

Behavioral Finance: Key Concepts - Gambler's Fallacy
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