Ask the Advisor: How Confirmation Bias Can Affect Your Investment Strategies

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Question: I read your post last week on Behavioral Finance. Can you tell me more about "confirmation bias?" How is it good or bad for me as an investor?

Confirmation bias is a technical name for the human desire to find information that agrees with their existing view. As I said in last week's post, Behavioral Finance 101, people don't like to be wrong so they tend to seek information that proves them right.

Often confirmation bias involves a pre-conceived bias to a particular outcome of an event occurring in the future. For example, if you were convinced that the Pittsburgh Steelers would win the Super Bowl, even though they were statistically an inferior team to the Green Bay Packers, you would seek any information to prove your position and disprove the opposing position. Taking your bias further, even after the Steelers lost the game, you convince yourself and others around you that the Steelers are truly the superior team but simply made a few uncharacteristic mistakes; therefore your prediction was still accurate.

"Faced with the choice between changing one's mind and proving there is no need to do so, almost everyone gets busy on the proof." ~ John Kenneth Galbraith

I would not go so far as to say that confirmation bias is inherently 'good' or 'bad;' it is simply a part of human nature. Confirmation bias, however, can be harmful to you as an investor. A classic case associated with confirmation bias is one where an investor is convinced that shares of a particular stock are about to significantly increase in value; the investor buys shares of the stock; the stock price falls; the investor denies that he is wrong and shrugs off the short-term loss as "a fluke;" the stock's share price continues to fall; the investor ignores signals that he should sell and cut his losses; and the stock price has now fallen so far that the investor may never recover the loss in value.

The lesson here is not that humans are all ignorant, prideful and self-destructive. It is a lesson of self-awareness. Being aware of your own biases and potential for reckless behavior is the primary means of preventing such behavior.

"The investor's chief problem--and even his worst enemy--is likely to be him self." ~ Benjamin Graham

Investing is a scientific process and it is a psychological process, both of which overlap. The foundation of scientific thought, as pertaining to the decision-making process, can be summed up in four words: Try to disprove yourself.

Knowing that you are likely to be your own worst enemy is the beginning of successful investing; and the awareness of confirmation bias is at the center of this success. Do you want to be "right" or do you want to be successful?

Kent Thune is a Certified Financial Planner™ and owner of an independent, "fee-only" investment management firm in Mount Pleasant, SC. Kent is also a freelance writer. To read more of his work or to find out how to contact Kent, please visit his blog at The Financial Philosopher. Have a question? Email AsktheAdvisor@savings.com.

_{Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment} ^{advice. Under no circumstances does this information represent a recommendation to buy or sell securities.}