Of all the cognitive traps open to investors, confirmation bias is arguably one of the easiest to fall into. But what is it and what steps can we take to minimise the role it plays in our decision-making? Read on and find out.
Put simply, confirmation bias is the tendency to take on new information so long as it conforms to our existing feelings or beliefs about something. If you firmly believe that politicians are inherently good people, for example, you’ll invariably look around for evidence to confirm this while ignoring or actively rejecting anything to the contrary. Exactly the same process occurs if you are adamant that all politicians are inherently bad.
It’s not hard to see the relevance of this to investing. Those who are absolutely convinced that markets are currently overvalued will look for evidence to back up this view. Those who vehemently believe that equities have further to run will do the same. Indeed, confirmation bias is a key reason why bull and bear markets persist. When something is popular, a lot of us fail to question what might cause prices to reverse. When times are tough, it’s easy to find reasons to back up our view that the world is going to hell in a handcart.
But our susceptibility to confirmation bias can go beyond general views on the market and have a huge impact on our opinions about specific companies. Everywhere you look you find reasons to invest in Next Big Thing plc: the track records of those in charge, its potential to disrupt an established industry or its highly innovative marketing strategy. Any question marks over the company — such as high debt levels and/or overly generous remuneration packages for directors — might be immediately dismissed. Meanwhile, another company, Destined To Fail plc looks set for oblivion based on the many articles you’ve read. But did you ignore those recent announcements detailing the appointment of an ambitious CEO and her intention to take the company in a new direction?
So, having become more aware of our tendency to look for information that does nothing more than agree with our own beliefs about something, what can we do to about it?
First — and perhaps fairly obviously — we need to learn to seek out opinions that differ from our own. Having the courage to deviate from our usual sources of information (which have a tendency to mirror our already entrenched values) should ensure that we avoid becoming too attached to our holdings. That said, it still pays to be careful when selecting ‘alternative’ sources. Far from helping us avoid it, bulletin boards can often be a breeding ground for confirmation bias.
Keeping a record of your investing decisions and why you made them can also help. Since no investment is devoid of risk, there should always be something in the column labelled ‘Why I might be wrong’. For a company like Fevertree, for instance, this might include an awareness that consumers can switch away from more expensive, branded goods during economic downturns. On the other hand, those considering selling battered FTSE 100 giant BT might wish to contemplate how positive news relating to its much-publicised pension deficit may impact on sentiment towards the company.
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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.