Following the recent discussion on Prospect Theory and the ways in which human nature leads to systematic flaws in our judgement, we thought we'd spend some time looking at one of the most relevant behavioural biases for investors - namely confirmation bias. This is the well documented tendency of people to favour information that confirms their beliefs or hypotheses, not only by hearing what they want to hear but also by seeking out those with similar opinions.
The (dangerous) power of YES
Confirmation bias has been observed in a very wide range of studies. In all walks of life, people seem to gather evidence and remember information selectively, and interpret it in a biased way. The Wall Street Journal cited a recent analysis with nearly 8,000 participants which found that people are twice as likely to seek information that confirms what they already believe as they are to consider evidence that would challenge those beliefs. Without realising it, we emphasise information which reinforces our view whilst tending to downplay, avoid or even ignore contradictory information.
One study of biased interpretation took place during the 2004 US presidential election and involved subjects who described themselves as having strong feelings about the candidates. They were shown apparently contradictory pairs of statements, either from George W. Bush, John Kerry or a politically neutral public figure and asked to decide whether or not each individual's statements were inconsistent. The study found that subjects were much more likely to interpret statements by the candidate they opposed politically as being contradictory.
How this impacts investing
In the world of investing, confirmation bias can lead to all kinds of avoidable mistakes, be it trading too often and making inappropriate/miguided investments. An example might be an investor hypothesizing that interest rates will rise. Typically, he will then seek out information to confirm this hypothesis - understandably so - but, in the process, the danger is that he will lose out on analyzing important facts that may indicate that interest rates are in fact on the decline.
Confirmation bias can also prevent us from objectively looking at an investment once we have already made it. Have you noticed that, as soon as you buy a stock, you start looking for reasons why you are right? Once a stock is bought, we tend to look for information that confirms the investment as a good…