My Passive Income Journal

How Confirmation Bias Can Hurt Your Investment Decisions

I’ve had to get real about my own confirmation bias. Confirmation bias is a phenomenon where individuals tend to seek, interpret and remember information that confirms their pre-existing beliefs or hypotheses, while ignoring or discounting information that contradicts them. It is a common cognitive bias that affects people in all areas of life, including investment decisions.

Investor confirmation bias is real – we all have it.

Confirmation bias can lead investors to ignore critical information and to make decisions that are not based on logic or evidence, but on emotions and biases. In this short article, we will explore how confirmation bias can hurt your investment decisions and what you can do to avoid it.

Understanding Confirmation Bias

Confirmation bias is a type of cognitive bias that affects the way we process information. It is a tendency to search for, interpret and remember information in a way that confirms our preexisting beliefs or hypotheses, while ignoring or discounting information that contradicts them. It’s a comfortable feeling from my experience. That’s what makes it so deceiving.

Confirmation bias is not necessarily a conscious decision, but rather an automatic process that occurs when we process information. It is a result of the brain’s natural tendency to simplify and categorize information in a way that makes it easier to understand and remember.

Confirmation bias can manifest in many different ways, including:

  • Seeking out information that confirms one’s beliefs and ignoring information that contradicts them.
  • Interpreting ambiguous information in a way that confirms one’s beliefs.
  • Discounting or dismissing information that contradicts one’s beliefs.
  • Focusing on information that supports one’s beliefs and ignoring information that does not.

How Confirmation Bias Affects Investment Decisions

Confirmation bias can have a significant impact on investment decisions. When investors are affected by confirmation bias, they tend to:

  • Ignore information that contradicts their beliefs. Investors who are affected by confirmation bias may ignore or downplay negative news about a company or a stock if it contradicts their beliefs about the company or the stock’s potential.
  • Overemphasize information that confirms their beliefs. Investors who are affected by confirmation bias may overemphasize positive news about an investment product or a stock if it confirms their beliefs about the company or the stock’s potential.
  • Make decisions based on emotions and biases, rather than logic and evidence. Investors who are affected by confirmation bias may make decisions based on their feelings and preferences, rather than on logic and evidence. This can lead to poor investment decisions and financial losses.

For example, an investor who believes that a certain stock is going to perform well may ignore negative news about the company and focus only on positive news. This may lead the investor to make a poor investment decision and suffer financial losses. Similarly, this can happen with investment products with high fees that appear to tick all our other investing boxes – the fees can be justified or ignored in our minds because the rest of the product seems so right. Not!

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Real Life Examples of Confirmation Bias Investing Disasters

There are many real-life examples of investors who have failed due to confirmation bias. Here are a few notable examples:

1. Long-Term Capital Management (LTCM)

LTCM was a hedge fund founded in 1994 by a group of Nobel laureates and Wall Street veterans. The fund relied on complex mathematical models to make investment decisions. However, the fund’s models were flawed, and the fund’s managers were overconfident in their ability to predict market movements. This led the fund to take on excessive risk and make large bets on a single strategy. When the market turned against the fund, it suffered massive losses and had to be bailed out by the Federal Reserve.

2. Enron

Enron was a large energy company that collapsed in 2001 due to accounting fraud. The company’s executives engaged in a number of fraudulent activities, such as hiding debt and inflating revenue, in order to make the company appear more profitable than it really was. However, many investors were blinded by the company’s reputation as a successful and innovative company, and consequently, failed to recognize the warning signs of fraud.

3. Bernie Madoff

Bernie Madoff was a well-respected investment advisor who was revealed to be running a Ponzi scheme in 2008. Madoff’s scheme had been operating for well over 20 years, and had taken in billions of dollars from investors. However, Madoff was able to continue the scheme for so long in part because many investors were unwilling to believe that such a respected figure could be involved in fraud.

4. Dot-com bubble

During the late 1990s, many investors became convinced that the internet was going to revolutionize the economy, and poured billions of dollars into internet-related companies. However, many of these companies had little or no revenue, and their valuations were based more on hype than on fundamentals. When the bubble burst in 2000, many investors lost large amounts of money.

In each of these cases, investors were influenced by confirmation bias, either by failing to recognize warning signs of risk or by becoming overly confident in their investment strategies.

By learning from these examples, investors can avoid making similar mistakes in the future.

How to Avoid Confirmation Bias in Investment Decisions

Confirmation bias can be difficult to avoid, but there are several strategies that investors can use to minimize its impact on their investment decisions. These strategies include:

  1. Be aware of confirmation bias.

The first step to avoiding confirmation bias is to be aware of it. Just knowing confirmation bias exists is a real eye-opener. Investors should recognize that they may have a tendency to seek out information that confirms their beliefs and to ignore information that contradicts them. By being aware of this tendency, investors can make a conscious effort to avoid it.

  1. Seek out information that contradicts your beliefs.

Investors should actively seek out information that contradicts their beliefs. This can help investors to gain a more balanced perspective and to make more informed investment decisions. Investors can do this by seeking out alternative viewpoints, reading financial news sources that present a range of perspectives, and consulting with experts who hold different opinions. AKA – be scientific.

  1. Consider the source of information.

Investors should consider the source of the information they are receiving. Information from reliable sources, such as reputable financial news sources or expert analysts, is more likely to be accurate and unbiased than information from unreliable sources. Do lots of digging around to find the basis of source information.

  1. Use a systematic approach to decision-making.

Investors should use a systematic approach to decision-making. This means using a set of predetermined criteria to evaluate investment opportunities, rather than relying on emotions or biases. A systematic approach can help investors to make more rational and objective decisions, and to avoid being swayed by confirmation bias. So, whip out the clipboard and sharpen the pencil!

  1. Keep an open mind.

Investors should keep an open mind and be willing to change their beliefs in the face of new evidence. This can be difficult, as it requires investors to admit that they may have been wrong in the past. However, being open-minded and willing to change one’s beliefs can lead to better investment decisions and higher returns. In my own case, moving from growth investing to income investing required me to completely change my tune about my approach to investing based on my specific needs. That was hard for me.

  1. Use a diverse set of information sources.

Investors should use a diverse set of information sources to gather information about potential investments. This can include financial news sources, expert analysts, social media and other sources of information. By using a diverse set of information sources, investors can gain a more comprehensive understanding of potential investments and avoid being swayed by a single source of information. Make sure information sources include detractors and well as supporters of the investing product or approach you are investigating.

  1. Avoid making decisions based on emotions.

Investors should avoid making decisions based on emotions, such as fear, greed or excitement. Emotions will almost always cloud judgment and lead to poor investment decisions. Investors should focus on objective criteria, such as financial metrics and market trends, when making investment decisions. When I was a growth investor, the gyrations of the stock market nearly drove me to emotional despair on a daily basis – as a result I ended out trading based on the emotion of the day. It was truly terrible.

  1. Seek out diverse perspectives.

Investors should seek out diverse perspectives when making investment decisions. This can include consulting with experts who hold different opinions, seeking out alternative viewpoints and considering a range of investment options. By seeking out diverse perspectives, investors can gain a more comprehensive understanding of potential investments and avoid being swayed by confirmation bias. Nevertheless, finding people that are actually qualified to comment is difficult and rare – and Insta/TikTok/Reddit are full of people who are NOT qualified to comment – just saying.

Of all the above 8 suggestions, I have found this one to be the most powerful.

In Conclusion

Confirmation bias is a common cognitive bias that affects investors in all areas of life. It can lead investors to make decisions based on emotions and biases, rather than on logic and evidence. By being aware of confirmation bias and using strategies to avoid it, investors can make more informed investment decisions and achieve better investment returns. Strategies such as seeking out information that contradicts one’s beliefs, using a systematic approach to decision-making, and keeping an open mind can help investors to avoid confirmation bias and make better investment decisions.

Cheers

Hugh Walker