What is confirmation bias in investing (and what should I do about it?)
Confirmation bias affects many investors, and it often goes overlooked. In this blog we are going to talk about the definition of confirmation bias, and an example of how it may affect an investor. Lastly, we’ll discuss how to manage it and the role a financial advisor plays in helping clients manage confirmation bias.
What is confirmation bias?
Confirmation bias is defined as the propensity to select information that aligns with our beliefs, while rejecting information that does not support them. Investors often apply lower standards to confirming information and higher standards to data that does not concur with their views. As a result, they are more likely to accept what they agree with and less likely to accept what they do not agree with.
Confirmation bias – example of how it affects investors
Let’s talk about how confirmation bias may potentially impact investors. Here’s a hypothetical example of confirmation bias.
- Keisha is a doctor and knows a great deal about the pharmaceutical industry.
- She believes there is tremendous growth potential for telemedicine, given her anecdotal experience as a physician.
- Keisha reads a Wall Street Journal article touting telemedicine start ups’ growth potential and decides to allocate a portion of her portfolio to several of the stocks mentioned.
- Keisha reads a Barron’s article about how telemedicine startups are likely to face heightened competition and reach a plateau of growth due to regulatory pressures. She dismisses this opinion as invalid.
In the example above, is Keisha making a truly unbiased decision? No. She is pursing the path of least resistance instead of asking the hard questions about the opinions against her hypothesis. Instead, she should have asked herself questions such as:
- Is there true validity to what the Barron’s article is saying?
- Is this a viable source?
- Do other reputable sources confer with this not-so-rosy picture of telemedicine startups?
- Am I missing something?
Of course, this is just a theoretical example that may not be construed as a real scenario. The purpose of our example is to conceptualize the way that confirmation bias leads investors to seek information that supports their beliefs, often leading them to make decisions based on incomplete information. It’s natural to do this; it feels good to think you’re right, and it feels bad to think you are wrong. It’s human nature.
But whatever the cause and reasons for it, confirmation bias is a danger to investors. It causes them to compromise objectivity and operate in a biased fashion, overlooking key data that should be employed in a proper research process.
So what can you do about it?
Can investing biases be overcome?
In other blogs, we’ve discussed how to overcome investor behavioral bias. Please refer to our discussion of action bias and its consequences for the detailed analysis.
In short, there are several ways to overcome confirmation bias in investing, ranging from behavioral controls training to mindfulness practice. But these biases are inextricably linked to our inner psyche as humans – and hard to get past on our own without another person to keep you centered.
We feel the best way that an investor may overcome confirmation bias, and the many other biases that investors face (projection bias, overconfidence bias, herd bias, etc.), is to work with a financial advisor who can coach you through it. Even the strongest of investors are subject to human flaw; having an independent third party who can advise you unemotionally is one of the best benefits of working with a wealth manager.
The role a financial advisor plays in correcting investor bias
The ironic thing about confirmation bias is this.
The contradictory information that an investor rejects is precisely the type of input that they should paying more attention to.
But unfortunately, when you’re making decisions from left (or right) of center, you won’t see that.
And that is where the danger comes in: when it gets to the point that you are making an off-balance investment decision. Educated, informed people can sometimes be their own worst enemy when it comes to investing – because they believe so strongly in their convictions that in a sense they create “blind spots.”
All investment decisions should be made with objectivity. There is zero room for emotion of any sort in the investment process, whether it be in selecting investments to buy, knowing when to buy, knowing when to sell, taking capital gains, managing the overall risk level of a portfolio, picking the right level of stocks vs. bonds, or any of the other crucial tasks that go into the process of managing wealth properly.
The financial advisor plays a key role in helping clients overcome confirmation bias, as well as any other investing biases that they may be subject to. In some cases, it useful for the investor to have a gentle reminder or nudge that they are overlooking facts that they shouldn’t. In other (more extreme) cases, the financial advisor will need to make a full-on case for why the opposing view is valid and should be considered. The extent to which a wealth manager must get involved to correct clients’ behavioral financial blunders will vary from one case to the next.
For investors who are serious about building long term wealth, a financial advisor really shouldn’t be a “nice to have.” Most people will eventually make a mistake at some point, and it can be very damaging if it is a major mistake in the latter stages of the wealth cycle.
Working with a financial advisor – finding the right one
A skilled financial advisor is trained in the biases that investors are subject to, and knows how to coach a client through it. The process should be collaborative and won’t make you feel like you’re being restricted but rather nurtured to a higher level of investing skill.
As financial advisors in Philadelphia working with clients across the country, behavioral coaching is our core value adds to the client. We provide fee-only, objective advice to our clients on taxes, wealth management, and financial planning. If you would like to discuss a possible relationship, contact us.