This is a guest post by Carson Brackney, writer for Personal Finance Analyst. Personal Finance Analyst is an online community of bloggers dedicated to taking the mystery out of money and helping you to live a happier, more successful life with the money you have.
What’s Confirmation Bias?
We usually look externally when discussing investment opportunities and smart money management. We look at companies, financial markets, trends, products, retirement investing, legislation and everything else under the sun in hopes of finding the most efficient route to financial well-being.
That external focus is an absolute necessity, but it’s only part of the process. Dealing with money inevitably involves personal decision making and individual psychology. If we don’t combine an outward focus with some introspection, we compromise our ability to make good decisions.
One of the classic examples of the need for more introspective thought with respect to investment involves what behavioral psychologists terms “confirmation bias”. Put simply, confirmation bias is the human tendency to seek out and process information that supports pre-existing beliefs.
Carol Tavris illustrated the concept in a political context in her book, Mistakes Were Made, by recounting a Lenny Bruce comedy routine. Bruce described two different groups of people watching the 1960 Nixon/Kennedy presidential debate. The Kennedy fans were ecstatic at JFK’s performance, convinced he was absolutely crushing Nixon.
In the next apartment, Nixon supporters were thrilled that their man was giving Kennedy a shellacking. Bruce claimed that even if one of the candidates had announced that he’d be a lousy President, that candidates supporters would say, “Now that’s an honest man for you. It takes a big guy to admit that. There’s the kind of guy we need for President.”
In other words, everything uttered by either man was going to be filtered through the confirmation bias of those who had already made a decision.
Confirmation Bias and Investing in Stocks and Mutual Funds
Confirmation bias exists in all areas of decision making. It’s subject to a great deal of scrutiny in the scientific and medical fields, where strict application of the scientific method is believed to minimize its effect. It’s also a topic of discussion in the investment and finance field. BloggingStocks lists confirmation bias as one of the three common investment mistakes, noting:
This so-called confirmation bias plays out in investor’s portfolios every day. That’s because if an investor buys a stock, he or she tends to look for information that makes them believe the stock will rise. Investors filter out any negative information. What they should do is ask an objective analyst to weigh all the pro’s and con’s and make a recommendation about what to do. But thanks to confirmation bias, most investors would ignore such advice anyway.
We become personally invested in our financial investment decisions. That leads us, quite naturally, to look for ways to make us feel better about our decisions and to support the conclusions that produced them. If we decide to sink our retirement savings into a particular mutual fund, for instance, there’s a strong likelihood that we’ll continue to seek out information that supports our decision.
The risk in all of this is that reinforcing our decisions at the expense of information than might influence us to make changes can leave us “married” to bad choices that harm our financial well-being. ArriveMoney explains the consequences of unchecked confirmation bias:
When it comes time to execute your trade, confirmation bias can be detrimental to your portfolio. If your confirmation bias leads you down the wrong path, your financial decisions may be prompted by psychological underpinnings – not unbiased market analysis.
Confirmation bias can undo all of that smart, outwardly focused investigation and research we do when making decisions in the first place.
How to Avoid Confirmation Bias in Our Financial Decisions
So, how can we actually avoid this pitfall? How can we consciously attempt to avoid a natural subconscious tendency? In the multivariate and inately human world of investment, application of the scientific method or some other objective strategy is impractical. There are, however, a few things we can do.
We need to make a conscious effort to seek out and to evaluate information on all sides of any money management argument. That can involve meaningful discussions with those who hold opposing viewpoints. It also means that we should try to understand “the other side of the trade“. Someone is willing to sell and you’re willing to buy (or vice versa). What are they thinking and why are they thinking that way? Understanding that can reduce the likelihood of falling victim to confirmation bias. We should also apply critical thinking skills to the materials we do encounter in our research, approaching them with a healthy degree of skepticism regardless of whether they support our preferences or not.
If you aren’t challenging your perspectives and testing your opinions regarding the decisions you’re making, you’re taking a risk. You may be giving your subconscious tendency toward confirmation bias an opportunity to significantly damage your bottom line.
Photo Credit: epicharmus