Confirmation bias and how it affects your investment decisions?
Created on 18 Sep 2020
Wraps up in 5 Min
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Updated on 04 Aug 2022
Our mind is divided between an elephant and a rider. We often think that the rider is the one who controls the elephant, but we often forget that the rider is only the guide.
We usually call our consciousness as the rider and our unconsciousness as the elephant. And it's this divide between them that makes us think that we are right, when in fact, we are wrong.
And guess what, it doesn't matter how smart you are, Or liberal, Or conservative. We all are, first and foremost, humans. This means that we are also biased towards ourselves, our beliefs, and our values.
As discussed in the previous blog, biases are thoughts that make us think in a certain way and often leads us to be wrong. It's sometimes unavoidable and hard to recognize. There are several different types of biases. But one of the most familiar to us is called the confirmation bias.
Let's consider an example; Manish wants to lose weight. He selects a diet plan and checks the weighing scale every morning. If he has lost weight, he pats himself on the back. If he has gained weight, he takes it as a normal fluctuation and forgets about it. For months he lives in the illusion that he is working even though his weight remains constant. Here, Manish is a victim of confirmation bias.
The question here is, why does this happen, and why do we only tend to see the evidence present on our side of the table?
What is confirmation bias?
Nowadays, we can avail information from so many sources. Our brains try to understand a lot of data, but they usually can't. So instead, it takes shortcuts and focuses on what we think is the most important information. These shortcuts get stored deeply in our unconscious mind and are the reason we create stereotypes.
For example, while growing up, we often consider the men in our life as the leaders and the women as caretakers. Think about it. Can you name one male you know who is a stay home dad?
Because of these life experiences, our brains create patterns and store them in our 'elephants' or unconsciousness.
These patterns then turn into generalized thoughts and expectations about most things. In this case of men and women, it turns out that these generalized thoughts are wrong in many cases. Women can make pretty great leaders, and men can be amazing stay home dads.
But even if the rider understands this, it's still hard to control what our elephants believe. This explains a lot about why our brains have these patterns and why we create stereotypes.
The confirmation bias is the mother of all misconceptions. It is the tendency to interpret new information in a way that makes you compatible with your existing beliefs. In other words, we filter out any new data or disconfirming evidence that contradicts our existing views. This is dangerous.
As Warren Buffet once noted, human beings are best at interpreting new information, so that their prior conclusions remain intact. Or humans simply oversee the facts by ignoring them. But how does this bias impact our investment decision? Let us see.
Confirmation bias and investment decisions
The confirmation bias also exists in the business world.
Let's say an executive team introduces a new strategy. The team, too, enthusiastically celebrates any sign that shows it's a success. Everywhere the executives look, they see plenty of confirming evidence. They see no indications that this strategy is failing. They quickly dismiss any red flags as exceptions or special cases. They are blind to the disconfirming evidence.
Confirmation bias does not only affect how we gather information, but also how we process and remember information. The bottom line is that we, as humans, tend to weigh the evidence that supports our prior belief to a greater degree than evidence that will contradict them.
The confirmation bias also messes up investment decisions. Let's suppose you decide to buy a mutual fund. You are sure it will make good money. Now your brain does something strange; it picks up evidence that confirms your opinion, through sources like a newspaper blog, reports, caste reports. The brain then automatically filters out the information that is opposing your view.
The facts that you noticed strengthen your existing ideas, even if they are wrong. This unreasonably increases your confidence as an investor. All this happens unconsciously, and you might not even be aware that your brain is doing it.
How can you fight confirmation bias in your investment decision?
1. Before each investment decision, actively search for disconfirming evidence. Seek any signal that what you are about to do is not a good move. The more accurate you think your theory is, the more actively you should look for disconfirmation. Make your decision only once you have actively sought out the reverse perspective.
2. Remember that behind every financial transaction you make, there will always be somebody who disagrees with you. If you are about to buy, there must be someone to sell. Ask yourself, what does the seller know that I don't know?
3. Situationalise your disconfirmation. There are many ways you can do this. One simple way is before making any investment, call one of your smart, trusted friends, and ask them to try to persuade you not to do it.
If they succeed, if their arguments are strong enough to make you abandon your investment, pay them something. Your friend gets paid only if you decide not to invest. Remember that you are paying them for their contradictory arguments, which is why they will try harder to convince you.
Your brain automatically filters out new information that contradicts your existing views. You confide the confirmation bias by seeking this conforming evidence and trying to undermine your theories. Trying to counter your beliefs may be the best way ultimately to support them.
It is also important to accept that you are wrong and simply admit those things for which we don't have an answer for. It's not enough to just have the knowledge of confirmation bias. Education alone cannot combat. One needs to implement and try measures not to get affected by such biases.
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