By: Flabia Maharjan
Cognitive biases can lead to poor investment decisions. Investing decisions are often a result of cognitive biases that make people act on emotions or encourage errors while processing information. People are always looking for an easy way out and in this process, they take mental shortcuts to simplify complex decision-making, which leads to irrationality and misinterpretation. Hence, a good understanding of cognitive biases allows investors to reduce potential risks and maximize their returns over time by avoiding such biases. Among many, we will discuss the tendency to seek information that confirms our existing beliefs, popularly known as confirmation bias.
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What is Confirmation Bias?
Confirmation bias encourages investors to accept information that coincides with their pre-existing beliefs. It leads investors to view an investment from a single side as they filter out all the facts and data that contradict their point of view. They become overconfident when they receive information that goes along with their pre-conceived notion and think nothing can go wrong. The damage to one and their respective investment can be enormous when things actually go wrong.
Types of Confirmation Bias
Here, we discuss three categories, which make up the confirmation bias. It involves seeking, interpreting, and retaining information that confirms our beliefs.
1. Biased Research
When individuals make a decision or develop a point of view, they search for facts and data that act as pieces of evidence to support their decision-making. They will try to gain confidence by looking for information that backs up their decisions, giving a false impression that they are on the right path. They ignore any argument presented against the idea revolving around their decision.
2. Biased Interpretation
This category touches upon how people evaluate data available to them. A piece of information that contradicts our existing beliefs will usually be ignored or neglected, while information that supports these beliefs will readily be accepted without criticism. This behavior is explained by the urge to remove discomfort caused by conflicting evidence. Hence, people are eager to interpret information that keeps their mental state in peace and provides validity to their opinions.
3. Biased Recall
Studies have shown that people are likely to remember information that aligns with their point of view while conflicting views have a higher chance of being forgotten. Hence, human memory filters out information that contradicts the current beliefs of an individual. In other words, people retain and recall information in a selective way showcasing biasness.
Confirmation Bias Amongst Investors
Confirmation bias makes investors inflexible to changes as people stick to and make decisions based on their existing investment philosophy. Reflection of one’s desires on their beliefs can be risky for investors as one shouldn’t be emotional while making investment decisions. Let us look at ways confirmation bias affects investors and their investment decisions.
1. Gathering Confirming Evidence
Supporting evidence can make investment decisions appear correct and rational. Therefore, investors look for confirming evidence when making investment decisions instead of evaluating all the data and resources available to them. They only ask questions that generate positive responses to their pre-existing beliefs. It makes an investor overconfident regarding his/her decision as any information against the decision has completely been ignored. As investors make decisions based on what they think is correct rather than looking at the bigger picture, the financial decisions are biased and investors miss out on relevant information important for decision-making.
2. Neglecting Portfolio Diversification
Diversification involves investing in a wide array of financial instruments, sectors, and asset classes in order to minimize the risk. Investors adopt this risk management strategy because an investor’s portfolio would contain stocks that react differently to the same event. It would not only minimize risks but maximize returns for the investor. However, investors with confirmation bias neglect diversification as they constraint themselves to limited companies and sectors. They fall into the pit of selectivity, where they select what information they use to make a particular investment decision. If they believe Company A to be a good company and even if there is a piece of unfavorable news regarding the company, they will ignore the information and choose to be committed to owning its shares, making the investment quite risky. Investors are exposed to the risk of company/sector downturns resulting in portfolio misalignment. Hence, confirmation bias causes investors to overinvest in a particular company or sector and disregard diversification, posing a greater threat to investors’ investments.
3. Suffering When Bubbles Burst
Investment bubbles are formed when the price of an asset rises far above its real value. One of the major reasons bubbles inflate is the herd behavior whereby investors purchase a stock because everyone is doing so. Confirmation bias makes investors follow the herd and invest in asset bubbles because they are highly influenced by what the majority believe in thus, ignoring contrarian views as to why the prices aren’t legitimate. When the asset bubbles burst, investors bear huge financial losses.
How to Overcome Confirmation Bias?
1. Seek Contrary Evidence
It is important to be aware that we’re instantly drawn to information that confirms our pre-existing beliefs, and it becomes easier to accept that kind of information. However, this can be disastrous for decision-making purposes. A quality decision-making process requires supporting evidence, but evidence contrary to our investment ideologies can be a good thing at times. It is because it helps us develop a better perception and reduce the chances of errors. Therefore, after we’re done collecting data that support our views regarding a particular investment, we must look for disconfirming information and evidence. Knowing both the good and bad sides of a particular investment can help us evaluate whether an investment is worth it or not. For this, we ought to assess the investment with an open mind by considering all the available information.
2. Avoid Affirmation Questions
We must avoid asking questions that support our conclusion regarding an investment. For instance, we’re drawn to a particular stock because its EPS is high. Then, we’re most likely to ask if the EPS is good enough. We’d hear the answer we want and buy stocks of that company, but there are numerous aspects that we’ve failed to consider before making our decision. Hence, it is always better to ask for an overview of the stock. The information obtained can lead to unbiased decision-making.
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