Confirmation Bias

Investors have their own opinions or pre-conceived notions. Seeking information or opinions that supports their ideas or pre-conceived notions and ignoring information that is contrary to their pre-conceived notions is confirmation bias. Confirmation bias is tested by a simple experiment. Investors are given 4 cards like the ones shown below. They are told that there is a letter or number on back of each card. Then they are asked to pick maximum 2 cards to test the hypothesis that “there will always be an even number of the back a card with a vowel”. Which 2 cards will you pick?

Most people pick up “A” and “4”. Having vowel behind “4” does not conclusively prove the hypothesis is right or wrong. At best you can say that hypothesis may be true. Instead if you picked 7 and found a vowel behind it, you would have conclusively said the hypothesis is wrong. Please remember this is not an intelligence test. It is a psychology test. When you were told that “there will always be an even number of the back a card with a vowel” you believed it to be true and try to confirm that it is true. This is confirmation bias.

This is like if a friend told you that Gold is always better than Equity and you look at last two-year asset class returns and feel confident about your friend’s opinion. You would ignore the period where Gold underperformed Equity.

Confirmation bias is seen in many aspects of life. For example, if you have a certain set of political beliefs, you would like to associate with friends you share your beliefs or like to follow political commentators, journalists or publications that affirm your belief. Similarly, if you like one sports team you will like to discuss about it with friends who support your team. People with confirmation biases are highly subjective and do not apply objectivity. This is harmful in investments.

How confirmation bias affects investment behaviour?

Confirmation bias is affirmation seeking behaviour. If you believe equity is risky then every time the market corrects 10% will be an affirmation while you ignore the periods when market was rising. Similarly, if you think Fixed Deposits (FDs) are better than debt funds, every time a bond gets downgraded or when yields rise and fund returns are impacted, you will seek to confirm your bias for FDs often ignoring other relevant information like returns of high credit quality funds, debt fund returns in favourable interest rate environments or tax efficiency of debt funds. Another example of confirmation bias may be a personal preference for a particular fund manager or fund house. You will tend to compare the performance of the fund manager with peers who would have underperformed him / her and not compare performance with peers who would have outperformed.

Confirmation bias leads to overconfidence about your investment strategy. Confirmation bias cause bulls to remain bullish or bears to remain bearish even when the market is too high or too low. Confirmation bias can provide explanations as to why some stocks trade at completely unreasonable valuations relative to their intrinsic value or why it may sometimes trade even below book value. More often than not, confirmation bias leads to sub-optimal investment decisions or even wrong investment decisions.

How to avoid confirmation bias?

  • Seek contrary opinions, even if those opinions may seem uncomfortable to you at first. Try to understand the rationale behind the contrarian opinions.
  • Do not rely on just one source of information to form opinions about a product. Look at multiple sources of information.
  • Knowledge is your biggest friend in overcoming investor biases. Increase your investment knowledge about different investment concepts, financial markets and the economy to make better investment decisions.

Confirmation bias is a psychological phenomenon which affects how we perceive things and make investment decisions. You should always be open to learning irrespective of what stage of life you are in.

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